I am undertaking a project that will cost $500 million to start up. It will be f

Question

I am undertaking a project that will cost $500 million to start up. It will be financed in equal parts of equity and nonrecourse debt. The debt will be 6% with an infinite term to maturity (interest only, forever), and the size of that debt load will be constant throughout the life of the project, which is indefinite. My firm’s tax rate is 35%. The total cash flows from the project will be approximately $35 million each year.

I have examined a number of comparable companies to my firm and discovered that most of them have similar equity betas. When I unlever these betas, I find the average unlevered beta for these comparable firms is 0.78. Assume a universal debt beta of 0.20, a market risk premium of 5%, and a risk-free rate of 3%.

1. When I start this project, how will it affect my total balance sheet size – what will the change be in total assets?

2. Assume I value this project using a FTTE (flow-through-to-equity) approach. What are my yearly cash flows? (Actual number!)

Explanation / Answer

Answer: Cost of equity is:

Ke=3%+0.2*5%

=4%

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