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sol2 - ACTSC 372 Assignment 2 Solutions 1[8 points P&P Inc...

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ACTSC 372 – Assignment 2 – Solutions 1. [8 points] P&P Inc. is a firm with an equity beta of 0.85. Its long-term debt currently has a yield- to-maturity of 5%. The current debt-to-equity ratio of the firm is 0.38 and the current corporate tax rate is 35%. The market risk premium is 8% and the risk-free rate is 3%. The company is considering a project that will generate annual after-tax cash flows of $210,000 at the end of each year for 4 years. The project requires an immediate investment of $800,000. (a) If the project has the same risk as the firm as a whole, should P& P undertake the project? (b) What is the smallest value for the annual after-tax cash-flow that would justify the project being undertaken? Solution: (a) The NPV is 210 , 000 a 4 e r - 800 , 000 where r = r wacc = B B + S r B (1 - T c ) + S S + B r S , where r S = r f + β ( μ M - r f ) = 0 . 098, so r wacc = 0 . 38 1 . 38 × 0 . 05 × 0 . 65 + 1 1 . 38 × 0 . 098 = 0 . 07996 . Hence the NPV is -104,397.27 so the project should not be undertaken. (b) The smallest value is 800 , 000 /a 4 e r = 241 , 517 . 16. 2. [8 points] Wheezie Inc. is considering undertaking a project that would generate after-tax cash flows of $100,000 for two years, and then $200,000 for the three next years. All cash flows occur at the end of the year. The firm has a debt-to-equity ratio of 0.6. The cost of equity is 14% and the before-tax
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