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HSBC Division is considering a new project costing $400 million. The project cost can be depreciated on a straight-line over 20 years. Part of the cost of the project will be financed with a new bond issue. In order to fnance a portion of new project, HSBC Division has sold for $93.54 million a twenty year, zero coupon bond with face value of $300 million. The issuance of debt will carry a one time cost at year 0 of $12.9 million. The issuance cost can not be depreciated or used to offset taxes. The project generates EBIT with an expected value of $40 million for each of the next twenty years, commencing one year after the start of the project. CFO believes that the debt obligation will be fulfilled with probability ONE, implying that the interest expense deductions associated with the tax-shield on the new debt have a zero covariance with the return on the market. The cash áows of the project do vary with the market, with the implied unlevered asset beta equal to 1.5. The expected return on the market is 12% and the risk-free rate is 6%. The CFO believes that the government is likely to push for an increase in the corporate income tax rate from 16% up to 28%, and ascribes a 75% chance that government will succeed in getting to pass the tax increase proposal. The CFO assumes that this event has zero covariance with the market portfolioís return and has no effect on the projects unlevered asset beta. He asks you to evaluate the project using APV. HSBC Division must make its accept/reject decision on BEFORE outcome of the government tax debate is known. (
(a) What are the expected annual after-tax Unlevered Cash Flows associated with the project?
(b) What is the discounted value (PV) of the after-tax Unlevered Cash Flow stream?
(c) Compute an amortization table for the bond.
(d) What is the value of the Debt Tax Shield associated with this project?
(e) What is the projectís APV? Should HSBC Division invest into project?
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