ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

# Project debentures npv deb npv is shown in 30 suppose

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Project Debenture’s NPV, Deb 0 NPV , is shown in (30). Suppose that the present value (using discount rate after tax,Deb WACC r - = 11.3%) of the forecasted Project Debenture free cash flow, Deb 0 V , and the estimated initial outlay for Project Debenture ( Deb 0 I ) are as indicated below. Deb 0 V = \$60 million (31a) Deb 0 I = \$40 million (31b) It follows that Deb 0 NPV equals: Deb 0 NPV = Deb 0 V - Deb 0 I = \$60 million - \$40 = \$20 million (32) Project Debenture is acceptable because Deb 0 NPV > 0. Project Debenture is adopted if the choice is to accept or reject Project Debenture. If Project Debenture is being compared with a mutually exclusive alternative, the one with the higher positive NPV is adopted. 24

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Estimating the WACC, page 25 of 25 S TEP 5. D ETERMINING THE F INANCING OF P ROJECT D EBENTURE S I NITIAL O UTLAY . The financing proportions in (28) (([ Deb 0 E / Deb 0 V ] and [ Deb 0 D / Deb 0 V ]) are target market value proportions established by the company for Project Debenture. Now we must determine Project Debenture’s initial outlay financing proportions ([ Deb,Debt 0 I / Deb 0 I ] and [ Deb,Equity 0 I / Deb 0 I ]). Since the market value of the additional debt issued to finance Project Debenture, Deb 0 D , equals the amount received by the company to fund the Project Debenture initial outlay, we know that: Deb,Debt 0 I = Deb 0 D (33) Noting that [ Deb 0 D / Deb 0 V ] = .25 (see (28)) and Deb 0 V = \$60 million (see (31)), it follows that: Deb 0 D = Deb 0 Deb 0 D V Deb 0 V = .25 (\$60 million) = \$15 million (34) Combining (33) and (34), we have: Deb,Debt 0 I = \$15 million (35) Using (29): Deb,Equity 0 I = Deb 0 I - Deb,Debt 0 I = \$40 million - \$15 million = \$25 million (36) Therefore, given that Deb 0 V = \$60 million and Deb 0 I = \$40 million, in order to meet market value target [ Deb 0 D / Deb 0 V ] = .25, the funds to finance Project Debenture’s initial cost ( Deb 0 I = \$40 million) must be from Deb,Debt 0 I = \$15 million and Deb,Equity 0 I = \$25 million . 2013(1) 25
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