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Unformatted text preview: vant. The $6 million land value in 5 years is a relevant cash flow as well. The fact that the company is keeping the land rather than selling it is unimportant. The land is an opportunity cost in 5 years and is a relevant cash flow for this project. The market value capitalization weights are: MVD = 240,000($1,000)(0.94) = $225,600,000 MVE = 9,000,000($71) = $639,000,000 MVP = 400,000($81) = $32,400,000 The total market value of the company is: V = $225,600,000 + 639,000,000 + 32,400,000 = $897,000,000 Next we need to find the cost of funds. We have the information available to calculate the cost of equity using the CAPM, so: RE = .05 + 1.20(.08) = .1460 or 14.60% The cost of debt is the YTM of the company’s outstanding bonds, so: P0 = $940 = $37.50(PVIFAR%,40) + $1,000(PVIFR%,40) R = 4.056% YTM = 4.056% × 2 = 8.11% And the aftertax cost of debt is: RD = (1 – .35)(.0811) = .0527 or 5.27% The cost of preferred stock is: RP = $5.50/$81 = .0679 or 6.79% a. The weighted average flotation cost is the sum of the weight of each source of funds in the capital structure of the company times the flotation costs, so: fT = ($639/$897)(.08) + ($32.4/$897)(.06) + ($225.6/$897)(.04) = .0692 or 6.92% The initial cash outflow for the project needs to be adjusted for the flotation costs. To account for the flotation costs: Amount raised(1 – .0692) = $35,000,000 Amount raised = $35,000,000/(1 – .0692) = $37,602,765 So the cash flow at time zero will be: CF0 = –$5,100,000 – 37,602,765 – 1,3000,000 = –$44,002,765 320 There is an important caveat to this solution. This solution assumes that the increase in net working capital does not require the company to raise outside funds; therefore the flotation costs are not included. However, this is an assumption and the company could need to raise outside funds for the NWC. If this is true, the initial cash outlay includes these flotation costs, so: Total cost of NWC including flotation costs: $1,300,000/(1 – .0692) = $1,396,674 This would make the total initial cash flow: CF0 = –$5,100,000 – 37,602,765 – 1,396,674 = –$44,099,439 b. To find the required return on this project, we first need to calculate the WACC for the company. The company’s WACC is: WACC = [($639/$897)(.1460) + ($32.4/$897)(.0679) + ($225.6/$897)(.0527)] = .1197 The company wants to use the subjective approach to this project because it is located overseas. The adjustment factor is 2 percent, so the required return on this project is: Project required return = .1197 + .02 = .1397 c. The annual depreciation for the equipment will be: $35,000,000/8 = $4,375,000 So, the book value of the equipment at the end of five years will be: BV5 = $35,000,000 – 5($4,375,000) = $13,125,000 So, the aftertax salvage value will be: Aftertax salvage value = $6,000,000 + .35($13,125,000 – 6,000,000) = $8,493,750 d. Using the tax shield approach, the OCF for this project is: OCF = [(P – v)Q – FC](1 – t) + tCD OCF = [($10,900 – 9,400)(18,000) – 7,000,000](1 – .35) + .35($35,000,000/8) = $14,531,250 e. The accounting breakeven sales figure for this project is: QA = (FC + D)/(P – v) = ($7,000,000 + 4,375,000)/($10,900 – 9,400) = 7,583 units 321 f. We have calculated all cash flows of the project. We just need to make sure that in Year 5 we add back the aftertax salvage value and the recovery of the initial NWC. The cash flows for the project are: Year 0 1 2 3 4 5 Flow Cash –$44,002,765 14,531,250 14,531,250 14,531,250 14,531,250 30,325,000 Using the required return of 13.97 percent, the NPV of the project is: NPV = –$44,002,765 + $14,531,250(PVIFA13.97%,4) + $30,325,000/1.13975 NPV = $14,130,713.81 And the IRR is: NPV = 0 = –$44,002,765 + $14,531,250(PVIFAIRR%,4) + $30,325,000/(1 + IRR)5 IRR = 25.25% If the initial NWC is assumed to be financed from outside sources, the cash flows are: Year 0 1 2 3 4 5 Flow Cash –$44,099,439 14,531,250 14,531,250 14,531,250 14,531,250 30,325,000 With this assumption, and the required return of 13.97 percent, the NPV of the project is: NPV = –$44,099,439 + $14,531,250(PVIFA13.97%,4) + $30,325,000/1.13975 NPV = $14,034,039.67 And the IRR is: NPV = 0 = –$44,099,439 + $14,531,250(PVIFAIRR%,4) + $30,325,000/(1 + IRR)5 IRR = 25.15% 322 CHAPTER 14 EFFICIENT CAPITAL MARKETS AND BEHAVIORAL CHALLENGES
Answers to Concepts Review and Critical Thinking Questions 1. To create value, firms should accept financing proposals with positive net present values. Firms can create valuable financing opportunities in three ways: 1) Fool investors. A firm can issue a complex security to receive more than the fair market value. Financial managers attempt to package securities to receive the greatest value. 2) Reduce costs or increase subsidies. A firm can package securities to reduce taxes. Such a security will increase the value of the firm. In addition, financing techniques involve many costs, such as accountants, lawyers, and investment bankers. Packaging securities in a way to reduce these costs will also increase the value of the firm. 3) Create a new security. A previou...
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 Spring '10
 eshmalwi
 Finance, Corporate Finance

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