Company A is considering a project (the only project for the company) with the f

Question

Company A is considering a project (the only project for the company) with the following estimated unlevered cash flows: (Two years life time for the company)

$2000

Company A finances its projects with 70% equity and 30% debt. The firm has calculated its cost of equity to be 12%. The corporate tax rate is 40% and interest on debt is tax deductible. The borrowing cost for the firm is 6%.

a) Using the FCFs and WACC to calculate the leveraged firm value [6 Marks]

b) Using the un-levered CF and Tax-Shied Cash Flows to calculate their present values (and the leveraged firm value equals the sum of the two) [6 Marks]

c) Will the results (of the leveraged firm value) in the above two be equal? (Simple answer with “Yes” or “No” is not enough; you should provide your explanation.) [8 Marks] Total [20 Marks]

Useful formulae for the Question : WACC=Re*We + Rd*Wd*(1-Tc) Re=Ru + (Ru-Rd) (D/E)  

$2000

Explanation / Answer

Levered cost of equity
Re=Ru+(Ru-Rd)*(D/E)
=12%+((12%-6%)*(30%/37%))
=14.57%
WACC=(after tax cost of dbet*wt of debt)+(Wt of equity*cost of equity)
=(6%*(1-40%)*30%)+(14.57%*70%)
=11.28%
a)value=(700/(1+11.28%)^1)+(1400/(1+11.28%)^2)
=1759.60

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