Valuing a leveraged firm
A firm has decided to take a project that requires an initial investment of $12,500,000. If funded entirely with equity, the firm expects the project to generate net (after tax) operating cash flows during the project’s twenty five year life as follows:
years 1-10 $1,925,000 per year
years 11-20 $2,025,000 per year
years 21-25 $2,125,000 per year
The firm also expects to net $10,000,000 (after tax) from sale of equipment and recovery of working capital at the end of the project (i.e., in year 25). The firm estimates that the asset beta for comparable projects is 1.43. The risk free interest rate is 4.0% and the firm expects the market return over the next 25 years to average 12.0%. The project will operate as a corporation with a combined federal and state income tax rate of 40%.
The firm plans to fund 35% of the project with debt that pays 4.0% interest annually for 25 years at which time the entire principal is due.
For all of the following, use annual cash flows and annual interest payments.
1a. Using the capital asset pricing model, determine the required return on the project if it is funded entirely with equity.
b. Calculate the net present value of the project if funded entirely with equity.
2a. Find the leveraged equity beta.
b. Calculate the required return on leveraged equity. (You may use the capital asset pricing model or calculate the return directly using the debt equity ratio, the return on unleveraged equity and the interest rate.)
c. Determine the weighted average cost of capital.
d. Using the WACC method, what is the net present value of the leveraged project?
3a. Calculate the amount of the each annual interest payment on the loan.
b. Calculate the present value of the interest payments.
c. Determine the value of the tax shield of interest.
d. Using the APV method, what is the net present value of the leveraged project?
4a. Determine the initial investment by equity in the project and the annual cash flows to equity for the project in years 1-10, years 11-20, and years 21-25 (Be sure to account for the cash flow from sale of equipment and recovery of working capital in year 25.)
b. Using the FTE method, what is the net present value of the leveraged project?