Corporate Finance Exercise Level of Debt

1643 Words7 Pages
1. Arden Corporation is considering an investment in a new project with an unlevered cost of capital of 9% Arden’s marginal corporate tax rate is 40%, and its debt cost of capital is 5%. a. Suppose Arden adjusts its debt continuously to maintain a constant debt-equity ratio of 50%. What is the appropriate WACC for the new project? Suppose Arden adjusts its debt once per year to maintain a constant debt-equity ratio of 50%. What is the appropriate WACC for the new project now? Alternatively, from Eq. 18.17: a. Suppose the project has free cash flows of $10 million per year, which are expected to decline by 2% every year. What is the value of the project in both cases? In case (a), . In case (b), . Note the minor difference in the two cases. Case (b) is higher because the tax shields are less risky when debt is fixed over the year. 2. XL sports is expected to generate free cash flows of $10 million per year. XL has permanent debt of $40 million, a tax rate of 40%, and an unlevered cost of capital of 10%. a. What is the value of XL’s equity using the APV method? VU = 10/ 10% = $100 million. PV(ITS) = 0.40 × $40 million = $16 million. VL = APV = 100 + 16 = $116 million, so E = 116 – 40 = $76 million. b . What is XL’s WACC? What is XL’s equity value using the WACC method? the WACC method, VL = 10 / 8.62% = $116 million, so E = 116 – 40 = $76 million. 1 c . If XL’s debt cost of capital is 5%, what is XL’s equity cost of capital? From Eq. 18.20: b . What is XL’s equity value using FTE method? FCFE = FCF – After-tax Interest + Net new debt = 10 – 5%(1 – 0.40)40 = 8.8 E = 8.8 / 0.1157 = $76 million. 3. In year 1, AMC will earn $2000 before interest and taxes. The market expects these earnings to grow at of 3% per year. The firm will make no net investments (i.e. capital expenditures will equal depreciation) or changes to net

More about Corporate Finance Exercise Level of Debt

Open Document