Ross5eChap18sm

Ross5eChap18sm - Chapter 18: Valuation and Capital...

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Chapter 18: Valuation and Capital Budgeting for the Levered Firm 18.1 a. The maximum price that Budget should be willing to pay for the fleet of cars with all–equity funding is the price that makes the NPV of the transaction equal to zero. NPV = –Purchase Price + PV[(1– T C )(Earnings Before Taxes and Depreciation)] + PV(CCA Tax Shield) Let P equal the purchase price of the fleet. NPV = –P + (1–0.38)(\$430,000)A 5 0.09875 + PVCCATS P x x x P PVCCATS 26016 . 0 09875 . 0 1 09875 . 0 5 . 0 1 09875 . 0 25 . 0 25 . 0 38 . 0 = + + + = Set the NPV equal to zero. 0 = –P + (1–0.38)(\$430,000)A 5 0.09875 + 0.26016P P = \$1,370,376.43 Therefore, the most that Budget should be willing to pay for the fleet of cars with all–equity funding is \$1,370,376.43. 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 Budget’s case, the NPV of financing side effects equals the after–tax present value of the cash flows resulting from the firm’s debt. APV = NPV(All–Equity) + NPV(Financing Side Effects) NPV(All–Equity) NPV = –Purchase Price + PV[(1– T C )(Earnings Before Taxes and Depreciation)] + PV(CCATS) Budget paid \$1,100,000 for the fleet of cars. 45 . 176 , 286 \$ 09875 . 0 1 09875 . 0 5 . 0 1 09875 . 0 25 . 0 25 . 0 38 . 0 ,100,000 1 = + + + = x x x PVCCATS NPV = –\$1,100,000 + (1– 0.38)(\$430,000)A 5 0.09875 + \$286,176.45 = \$200,036 NPV(Financing Side Effects) The net present value of financing side effects equals the after–tax present value of cash flows resulting from the firm’s debt. Answers to End-of-Chapter Problems B- 23

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NPV(Financing Side Effects) = Proceeds – After–Tax PV(Interest Payments) – PV(Principal Payments) Given a known level of debt, debt cash flows should be discounted at the pre–tax cost of debt (r B ), 7%. NPV(Financing Side Effects) = \$850,000 – (1 – 0.38)(0.07)(\$850,000)A 5 0.07 – [\$850,000/(1.07) 5 ] = \$92,705 APV APV = NPV(All–Equity) + NPV(Financing Side Effects) = \$200,036+ \$92,705 = \$292,741 Therefore, if Budget uses \$850,000 of five–year, 7% debt to fund the \$1,100,000 purchase, the Adjusted Present Value (APV) of the project is \$292,741. c. To determine the maximum price, set the APV=0 = NPV (All equity) + NPV(Loan) 0 = –P + (1–0.38)(\$430,000)A 5 0.09875 + 0.26016P + \$850,000 – (1 – 0.38)(0.07)(\$850,000)A 5 0.07 – [\$850,000/(1.07) 5 ] P = \$1,495,680.55 18.2 The adjusted present value of a project equals the net present value of the project under all–equity financing plus the net present value of any financing side effects. In the joint venture’s case, the NPV of financing side effects equals the after–tax present value of cash flows resulting from the firms’ debt. APV = NPV(All–Equity) + NPV(Financing Side Effects) NPV(All–Equity) NPV = –Initial Investment + PV[(1 – T C )(Earnings Before Interest, Taxes, and Depreciation )] + PV(CCA Tax Shield) Since the initial investment will be fully depreciated over five years using the straight–line method, annual depreciation expense is: Annual depreciation = \$42,000,000/5 Annual depreciation = \$8,400,000 NPV = –\$42,000,000 + [(1–0.38)(\$4,340,000)A 30 0.145 ] + \$8,400,000 x 0.38x A 5 0.145 = –\$12,934,185.97 NPV(Financing Side Effects) The NPV of financing side effects equals the after–tax present value of cash flows resulting from the firms’ debt.
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This note was uploaded on 07/18/2010 for the course ECONMICS ECM359 taught by Professor Matazi during the Summer '10 term at University of Toronto.

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Ross5eChap18sm - Chapter 18: Valuation and Capital...

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