MGMT310_lecture22 - Example Example: Firm X has an...

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xample: NPV with flotation cost Example: NPV with flotation cost Firm X has an investment opportunity for which it must pay $100,000 upfront. It has estimated the following future cash flows from this project: CF 1 = $20,000 CF 2 = $25,000 CF 3 = $50,000 CF 3 = $50,000 CF 5 = $50,000 ACC 8% MV(E) = $600 million MV(D) = $400 million This project is riskier than average compared to Firm X’s typical investments. Thus, the manager has decided to use its WACC + 2% as the WACC X = 8% occ for this project. Suppose that the firm’s flotation cost of debt is 2% of the amount issued, d at e rm lans nly se ternally nerated sh ver e and that the firm plans only to use internally generated cash to cover the equity portion of their capital spending (i.e., flotation cost of equity is 0%). ** Assume that the firm is currently at its target capital structure. h t PV f i jt i What is the NPV of thi sp roject (assuming themanage r has chosen an appropriate occ)? Should Firm X invest? **you can ignore tax treatment
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REVIEW: homemade leverage (still in perfect, frictionless world…) Firm X: unlevered (structure 1) No debt, $8 million equity (400,000 shares Firm X: levered (structure 2) Issue $4 million debt to buy back stock outstanding, $20 per share) Bust Normal Boom Now: 200,000 shares outstanding, and $4 million debt outstanding (@ 10% interest) Bust Normal Boom EBIT $500K $1,000K $1,500K Interest ‐‐‐ ‐‐‐ ‐‐‐ NI $500K $1,000K $1,500K EBIT $500K $1,000K $1,500K Interest 400K 400K 400K NI $100K $ 600K $ 600K Suppose you own 100 shares of Firm X. l l If Fi X i ld (t t 1)bt di th ff h f EPS $1.25 $2.50 $3.75 EPS $0.50 $3.00 $5.50 1. Recall: If Firm X is unlevered (structure 1), but you desire the payoff scheme from the levered version of Firm X (structure 2), then you can replicate your desired payoffs through homemade leverage .
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This note was uploaded on 01/21/2011 for the course MGMT 310 taught by Professor Matthewjamesbarcaskey during the Spring '08 term at Purdue.

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MGMT310_lecture22 - Example Example: Firm X has an...

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