Question Case

Question 1

Assuming the firm was entirely financed, using the CAPM,

E(ri)=Rf+ßim(E(rm)-Rf)=5%+1.5*7.2%=15.8%

The expected return of the project by entirely financed is about 15.8%.

The annual projected free cash flow is as follows:

Year 2002 2003 2004 2005 2006

Formula -20(1-40%)+200 135(1-40%)+225 335(1-40%)+250 565(1-40%)+275 825(1-40%)+300

Free cash flow 188 306 451 614 795

Since there’s no debt in the project, the discount rate of 15.8% is appropriate.

The value of the project:

-1500+440/1.05+440/1.05^2+…+440/1.05^5+188/1.158+306/1.158^2+

405/1.158^3+614/1.158^4+795/1.158^5

=1809.2

Question 2

Assuming the firm raises $750 thousand of debt to fund the project and keeps the level of debt constant in perpetuity,

Since APV=Base-case NPV +PV(Tax Shield) and Rd is 6.8% calculated by the CAPM.

Base-Case NPV=-750+188/1.158+306/(1.158^2)+451/(1.158^3)+614/

(1.158^4)+795/(1.158^5)

=654.23

PV(Tax-Shield)=(750*0.068*0.4)/1.068+(750*0.068*0.4)/(1.068^2)+

(750*0.068*0.4)/(1.068^3)+ (750*0.068*0.4)/(1.068^4)

+(750*0.068*0.4)/(1.068^5)

=84.09

APV=654.23+84.09=738.32

Question 3

Assuming the firm maintains a constant 25% debt-to-market value ratio