QUESTION 2: DealSeekers Limited has a target debt/equity ratio of 0.40, required

Question

QUESTION 2:
DealSeekers Limited has a target debt/equity ratio of 0.40, required rate of return on equity of 15%, and borrows at an interest rate of 9%. It is planning to invest in a new project which is expected to have debt/equity ratio of 0.70. It is expected that starting one year from today sales revenue for the project will be $2,500,000, variable cost $1,000,000, new investment $800,000, and depreciation $800,000 per year in perpetuity. The corporate tax rate is 40%.a.How much is the project worth in unleveraged form?b.If the project had the debt/equity ratio of 0.70, how much would it worth?c.Show that the earnings to shareholders and the required return on equity would justify the market value of the equity of the project.

Explanation / Answer

(a) Revenue = $ 2500000

LESS: Variable Cost = $ 1000000

LESS: Depreciation = $ 800000

Taxable Income = $ 700000

LESS: Tax @ 40 % = $ 280000

Net Income = $ 420000

ADD: Depreciation = $ 800000

LESS: New Investments = $ 800000

FCFF = Net Income + Depreciation - New Investments = $ 420000

If the project is assumed to be unlevered then the entire free cash flow (FCFF) to firm accrues to the firm's shareholders and the appropriate discount rate in such a scenario is equal to the firm's required return on equity.

Project Worth = 420000 / 0.15 = $ 2800000

(b) Project Debt/Equity = 0.7

Debt Proportion = (0.7/1.7) and Equity Proportion = (1/1.7)

WACC = (0.7/1.7) x 9 x (1-0.4) + (1/1.7) x 15 = 11.047 %

Revenue = $ 2500000

LESS: Variable Cost = $ 1000000

LESS: Depreciation = $ 800000

EBIT = $ 700000

LESS: Tax @ 40 % = $ 280000

NOPAT(Net Operating Profit After Tax) = $ 420000

FCFF = NOPAT + Depreciation - New Investment = $ 420000

Project Worth = 420000 / 0.11047 = $ 3801937.18

(c) Project Worth = $ 3801937.18

Equity Value = (1/1.7) x 3801937.18 = $ 2236433.635

FCFE = 0.15 x 2236433.635 = $ 335465.0453

FCFE = Net Income + Depreciation - New Investment = Shareholders' Earnings = 335465.0453 + 800000 - 800000 = $ 335465.0453

Return on Equity = 335645.0453 / 2236433.635 ~ 0.15 or 15 %

Hence, the equity value is justified.

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