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# BD_SM18 - Chapter 18 Capital Budgeting and Valuation with...

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Chapter 18 Capital Budgeting and Valuation with Leverage Explain whether each of the following projects is likely to have risk similar to the average risk of the firm: a. While there may be some differences, the market risk of the cash flows from this new product is likely to be similar to Clorox’s other household products. Therefore, assuming it has the same risk as the average risk of the firm is reasonable. b. A real estate investment likely has very different market risk than Google’s other investments in internet search technology and advertising. It would not be appropriate to assume this investment as risk equal to the average risk of the firm. c. An expansion in the same line of business is likely to have risk equal to the average risk of the business. d. The theme park will likely be sensitive to the growth of the Chinese economy. It’s market risk may be very different from GE’s other division, and from the company as a whole. It would not be appropriate to assume this investment as risk equal to the average risk of the firm. E = 665 million × \$74.77 = \$49.7 billion, D = \$25 billion, D/E = 25/49.722 = 0.503. E = 700 million × \$83.00 = \$58.1 billion. Constant D/E implies D = 58.1 × 0.503 = \$29.2 billion. Intel’s debt is a tiny fraction of its total value. Indeed, Intel has more cash than debt, so its net debt is negative. Intel is also very profitable – at an interest rate of 6%, interest on Intel’s debt is only \$132 million per year, which is less than 1.5% of its EBIT. Thus, the risk the Intel will default on its debt is extremely small. This risk will remain extremely small even if Intel borrows an additional \$1 billion. Thus, adding debt will not really change the likelihood of financial distress for Intel (which is nearly zero), and thus will also not lead to agency conflicts. As a result, the most important financial friction for such a debt increase is the tax savings Intel would receive from the interest tax shield. A secondary issue may be the signaling impact of the transaction – borrowing to do a share repurchase is usually interpreted as a positive signal that management may view the shares to be under- priced. We can compute the levered value of the plant using the WACC method. Goodyear’s WACC is wacc 1 2.6 r 8.5% 7%(1 0.35) 5.65% 1 2.6 1 2.6 = + - = + + Therefore, L 1.5 V \$47.6 million 0.0565 0.025 = = - A divestiture would be profitable if Goodyear received more than \$47.6 million after tax.

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136 Berk/DeMarzo • Corporate Finance a. wacc 10.8 14.4 10.8 r 10% 6.1%(1 0.35) 8.49% 14.4 14.4 - = + - = b. Using the WACC method, the levered value of the project at date 0 is L 2 3 50 100 70 V 185.86 1.0849 1.0849 1.0849 = + + = Given a cost of 100 to initiate, the project’s NPV is 185.86 – 100 = 85.86. c. Lucent’s debt-to-value ratio is d = (14.4 – 10.8) / 14.4 = 0.25. The project’s debt capacity is equal to d times the levered value of its remaining cash flows at each date: a. We don’t know Acort’s equity cost of capital, so we cannot calculate WACC directly. However, we can compute it indirectly by estimating the discount rate that is consistent with Acort’s market value. First, E = 10 × 40 = \$400 million. The market value of Acort’s debt is 4 4 1 1 100 D 10 1 \$113.86 million 0.06 1.06 1.06 = × - + =
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