You are looking at an investment for your firm. You can buy a manufacturing plan
ID: 2802864 • Letter: Y
Question
You are looking at an investment for your firm. You can buy a manufacturing plant for your firm for $90 million. You consider this investment to be of average risk to your company. You believe that there are three possible scenarios for this investment:
The investment generates a steady stream of FCFs of $15 million per year into perpetuity (with a probability of 40%)
The investment generates a steady stream of FCFs of $9 million per year into perpetuity (with a probability of 30%)
The investment generates a steady stream of FCFs of $4 million per year into perpetuity (with a probability of 30%)
You also are aware that you can sell the manufacturing plant next year for $75 million if the firm wants to get out from the investment.
Your most similar competitor (in terms of business products, customers, and geography) has a target capital structure (market value) of 50% debt and 50% equity. Their equity beta is 1.6. The target capital structure (market value) of your firm is 30% debt and 70% equity. The marginal tax rate for both firms is 35%.
The yield on long-term U.S. Treasuries is 3%. The yield on your firm’s bonds is 4.5%. And the market risk premium is 7%.
What is the appropriate discount rate for this project?
What is the NPV of this investment? Show your work.
Describe the rights puzzle of corporate financing. In your answer, give the possible explanations for why this puzzle exists. Be as complete as you can
Explanation / Answer
Perpetual fcfs from the project = probability * fcf = 15*40%+9*30%+4*30% = 6 + 3 + 1.2 = $10.2 M
cost of equity = risk free rate + beta * (market return - risk free rate) = yield on long-term U.S. Treasuries + beta * market risk premium = 3% + 1.6 * 7% = 14.2%
WACC = cost of debt * (debt/assets) * (1- tax rate) + (equity/assets) * cost of equity
= yield on your firm’s bonds *(30%) * (1-.35) + 70% * 14.2% = 0.8775% + 9.94% = 10.82%
This is the appropriate discount rate.
NPV will be the higher of holding to perpetuity or selling after a year
Holding to perpetuity PV = fcf/wacc = 10.2/.1082 = $ 94.3 M
NPV in this case = PV -investment = $ 94.3 M - $ 90 M = $ 4.3 M
If sold after a year, PV = fcf/(1+wacc) + sale price = 10.2/1.1082 + 75 = 9.2+75 = $ 84.2 M
NPV = 84.2 -90 = -$ 5.8 M
Hence NPV is $4.3 M
The rights puzzle is when the company sells stock to new shareholders for less than the market price, and the buyer makes a profit at the expense of existing shareholders.
In this case it is puzzling that they are considering selling the project for $ 75 M, and incurring a loss.
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