Corporate Finance

Questions and Practice problems_Chapter 18

Chapter 18:
Concept questions (page 574 textbook): 2, 3, 4
Questions and Problems (page 575 textbook): 3, 5, 8

Answer:
Concept questions (page 574 textbook)
2. What is the main difference between the WACC and APV methods?
APV is a type of DCF valuation method that values the firm's operations assuming it is entirely
equity financed (no leverage) - and thus discounted at the cost of equity - and then separately
values interest tax shields, NOLs, or other non-operating assets at appropriate discount rates.
When a firm's capital structure is expected to change significantly over the investment horizon,
APV is frequently used because it is easier to value interest tax shields this way.
WACC is a discount rate used as part of a DCF valuation when capital structure is expected to
remain relatively stable. It weights the discount rate used to value the firm (or project) based on
the after-tax cost of each source of capital (debt, equity, etc.). Using WACC as the discount rate
values the interest tax shields associated with the use of debt without having to value it
separately.
Because the valuation is completed in a single step, using WACC as the discount rate is
generally easier. However, in some cases, the APV method is required. The end result should be
the same regardless of which method is used.
3. What is the main difference between the FTE approach and the other two approaches?
FTE calculate the FCF available to equity holders after taking into account all payments to and
from debt holders. Wacc and apv are based on FCF only.
4. You are determining whether your company should undertake a new project and have
calculated the NPV of the project using the WACC method when the CFO, a former
accountant, notices that you did not use the interest payments in calculating the cash flows
of the project. What should you tell him? If he insists that you include the interest
payments in calculating the cash flows, what method can you use?
The WACC method does not explicitly include the interest cash flows, but it does implicitly
include the interest cost in the discount rate (i.e., the WACC).
If he insists that the interest payments are explicitly shown, you should use the FTE method.
Questions and Problems (page 575 textbook)
3. Milano Pizza Club owns three identical restaurants popular for their specialty pizzas.
Each restaurant has a debt–equity ratio of 40 percent and makes interest payments of
$41,000 at the end of each year. The cost of the firm’s levered equity is 19 percent. Each
store estimates that annual sales will be $1.3 million; annual cost of goods sold will be
$670,000; and annual general and administrative costs will be $405,000. These cash flows
are expected to remain the same forever. The corporate tax rate is 40 percent.
a. Use the flow to equity approach to determine the value of the company’s equity.
b. What is the total value of the company?

a. B/S = .3S/(B+S) = 10/13

EBIT = 1,000,000 – 400,000 – 300,000 = 300,000

b. Firm value = equity value / (10/13) = 810,000 * (13/10) = 1,053,000

5. North Pole Fishing Equipment Corporation and South Pole Fishing Equipment
Corporation would have identical equity betas of 1.10 if both were all equity financed. The
market value information for each company is shown here:
North Pole South Pole
Debt $2,900,000 $3,800,000
Equit
$3,800,000 $2,900,000
y

The expected return on the market portfolio is 10.9 percent, and the risk-free rate is 3.2
percent. Both companies are subject to a corporate tax rate of 35 percent. Assume the beta
of debt is zero.
a. What is the equity beta of each of the two companies?
b. What is the required rate of return on each of the two companies’ equity?
a. Unlevered or Asset beta of south pole and North pole = 1.10
Tax rate is 35% or 0.35
Levered beta or Equity beta formula = Unlevered or Asset beta * (1 +( (1-tax rate)*Debt/Equity))
North pole equity Beta = 1.10*(1+((1-0.35)* $2,900,000/$3,800,000)) = 1.65
South Pole equity Beta = 1.10*(1+((1-0.35)* $3,800,000/$2,900,000)) = 2.04
b. Risk free rate of return = 3.2%
Market Return = 10.9%
Required Return on equity formula as per CAPM method = Risk free rate +(Equity beta*(Market
Return-Risk free rate))
North Pole Required Return of equity = 3.2%+(1.65*(10.9%-3.2%)) = 15.91%
South Pole Required Return of equity = 3.2%+(2.04*(10.9%-3.2%)) = 18.91%
8. Electric Company (NEC) is considering a $45 million project in its power systems
division. Tom Edison, the company’s chief financial officer, has evaluated the project and
determined that the project’s unlevered cash flows will be $3.1 million per year in
perpetuity. Mr. Edison has devised two possibilities for raising the initial investment:
Issuing 10-year bonds or issuing common stock. NEC’s pretax cost of debt is 6.9 percent,
and its cost of equity is 10.8 percent. The company’s target debt-to-value ratio is 80
percent. The project has the same risk as NEC’s existing businesses, and it will support the
same amount of debt. NEC is in the 34 percent tax bracket. Should NEC accept the
project?
Given:
Project: $45 mil
Unlevered cash flows = $3.1 mil (perpeptuity)
Issue 10 year Bond
Issue common stock
Rd: (pretax) 6.9% (cost of debt)
Re: 10.8% (cost of equity)
D/V: 80%--> E/V: 0.2 -> D/E: 4
Same risk between: NEC & tom edition
NEC tax: 34%
D/E = 0.8
Use WACC method:
WACC = (E/V)*Re + (B/V)*Rb*(1-Tc) = 0.2*10.8% + 0.8*6.9%*(1-0.34)= 0.058
NPV = (Annual CF/WACC)- Initial investment of project = 3,100,000/0.058032 – 45,000,000
= 8,418,803.4 => ACCEPT
If the unlevered CF is not give, you can calculate it using the following income statement (which
is similar to when you calculate LCF-Levered cash flow), but don't subtract interest expense:
Sales
-COGS
-SG&A expenses
= EBIT
-Taxes
= Net income (unlevered CF)