You are a consultant who has been hired to evaluate a new product line for Marku
ID: 2785766 • Letter: Y
Question
You are a consultant who has been hired to evaluate a new product line for Markum Enterprises. The upfront investment required to launch the product line is $5 million. The product will generate free cash flow of $0.71 million the first year, and this free cash flow is expected to grow at a rate of 5% per year. Markum has an equity cost of capital of 10.6%, a debt cost of capital of 6.84%, and a tax rate of 38%. Markum maintains a debt-equity ratio of 0.60 a. What is the NPV of the new product line (including any tax shields from leverage)? b. How much debt will Markum initially take on as a result of launching this product line? c. How much of the product line's value is attributable to the present value of interest tax shields?Explanation / Answer
WACC = ((1/1.6) * 10.6%) + ((0.6/ 1.6) * 6.84% * 0.62)
WACC = 8.22%
NPV = - 5 + 0.71/ (8.22% - 5%)
NPV = - 5 + 22.08
NPV = 17.08 million
Part B
Amount of debt:
1/0.6 (Debt) + Debt = 5
Debt = 1.88 million
Part C
Unlevered Rate = (10.6% + (6.84% * 0.62 * 0.60))/ (1 + (0.62 * 0.60))
Unlevered Rate = 9.58%
Value of Unlevered firm = 0.71/ (9.58% - 5%)
Value of unlevered firm = 15.50 million
PV of ITS = 22.08 - 15.50
PV of ITS = 6.58 million
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