Unformatted text preview: hield will be created by issuing debt. Therefore, the firm will receive no tax benefit as a result of issuing debt in place of equity. In other words, the effective corporate tax rate when we consider the change in the value of the firm is zero. Debt will have no effect on the value of the firm since interest payments will not be tax deductible. Since this firm is able to deduct interest payments, the change in value is: Change in value = {1 – [(1 – 0) / (1 – .20)]} × $1 Change in value = –$0.25 The value of the firm will decrease by $0.25 if it adds $1 of perpetual debt rather than $1 of equity. 10. a. If the company decides to retire all of its debt, it will become an unlevered firm. The value of an allequity firm is the present value of the aftertax cash flow to equity holders, which will be: VU = (EBIT)(1 – tC) / R0 VU = ($1,300,000)(1 – .35) / .20 VU = $4,225,000 b. Since there are no bankruptcy costs, the value of the company as a levered firm is: VL = VU + {1 – [(1 – tC) / (1 – tB)}] × B VL = $4,225,000 + {1 – [(1 – .35) / (1 – .25)]} × $2,500,000 VL = $4,558,333.33 c. The bankruptcy costs would not affect the value of the unlevered firm since it could never be forced into bankruptcy. So, the value of the levered firm with bankruptcy would be: VL = VU + {1 – [(1 – tC) / (1 – tB)}] × B – C(B) VL = ($4,225,000 + {1 – [(1 – .35) / (1 – .25)]} × $2,500,000) – $400,000 VL = $4,158,333.33 The company should choose the allequity plan with this bankruptcy cost. 375 CHAPTER 18 VALUATION AND CAPITAL BUDGETING FOR THE LEVERED FIRM
Answers to Concepts Review and Critical Thinking Questions 1. 2. 3. 4. APV is equal to the NPV of the project (i.e. the value of the project for an unlevered firm) plus the NPV of financing side effects. The WACC is based on a target debt level while the APV is based on the amount of debt. FTE uses levered cash flow and other methods use unlevered cash flow. The WACC method does not explicitly include the interest cash flows, but it does implicitly include the interest cost in the WACC. If he insists that the interest payments are explicitly shown, you should use the FTE method. You can estimate the unlevered beta from a levered beta. The unlevered beta is the beta of the assets of the firm; as such, it is a measure of the business risk. Note that the unlevered beta will always be lower than the levered beta (assuming the betas are positive). The difference is due to the leverage of the company. Thus, the second risk factor measured by a levered beta is the financial risk of the company. 5. Solutions to Questions and Problems NOTE: All endofchapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. a. The maximum price that the company should be willing to pay for the fleet of cars with allequity funding is the price that makes the NPV of the transaction equal to zero. The NPV equation for the project is: NPV = –Purchase Price + PV[(1 – tC )(EBTD)] + PV(Depreciation Tax Shield) If we let P equal the purchase price of the fleet, then the NPV is: NPV = –P + (1 – .35)($140,000)PVIFA13%,5 + (.35)(P/5)PVIFA13%,5 Setting the NPV equal to zero and solving for the purchase price, we find: 0 = –P + (1 – .35)($140,000)PVIFA13%,5 + (.35)(P/5)PVIFA13%,5 P = $320,068.04 + (P)(0.35/5)PVIFA13%,5 P = $320,068.04 + .2462P .7538P = $320,068.04 P = $424,609.54 b. The adjusted present value (APV) of a project equals the net present value of the project if it were funded completely by equity plus the net present value of any financing side effects. In this case, the NPV of financing side effects equals the aftertax present value of the cash flows resulting from the firm’s debt, so: APV = NPV(AllEquity) + NPV(Financing Side Effects) So, the NPV of each part of the APV equation is: NPV(AllEquity) NPV = –Purchase Price + PV[(1 – tC )(EBTD)] + PV(Depreciation Tax Shield) The company paid $395,000 for the fleet of cars. Because this fleet will be fully depreciated over five years using the straightline method, annual depreciation expense equals: Depreciation = $395,000/5 Depreciation = $79,000 So, the NPV of an allequity project is: NPV = –$395,000 + (1 – 0.35)($140,000)PVIFA13%,5 + (0.35)($79,000)PVIFA13%,5 NPV = $22,319.49 NPV(Financing Side Effects) The net present value of financing side effects equals the aftertax present value of cash flows resulting from the firm’s debt, so: NPV = Proceeds – Aftertax PV(Interest Payments) – PV(Principal Payments) Given a known level of debt, debt cash flows should be discounted at the pretax cost of debt RB. So, the NPV of the financing side effects are: NPV = $260,000 – (1 – 0.35)(0.08)($260,000)PVIFA8%,5 – [$260,000/(1.08)5] NPV = $29,066.93 So, the APV of the project is: APV = NPV(AllEquity) + NPV(Financing Side Effects) APV = $2...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of TexasTyler.
 Spring '10
 eshmalwi
 Finance, Corporate Finance

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