Reference no: EM133290996
(a) A firm has a project: project A. Evaluate this project and evaluate whether the firm should or should not invest in Project A. Please report a specific NPV estimate for this project.
Your firm is a large conglomerate with operations in multiple industries and across the globe. Your firm has equity worth $800M and debt worth $400M. Your debt is considered riskless and has a cost of debt of 4%. (Thus, the risk-free rate is 4%). You have multiple lines of business that are very profitable and so you consider any interest tax shields savings to be of low risk. Specifically, you estimate the risk of your interest tax shields as (market) risk-free and thus you discount them at the risk-free rate of 4%. Because you are so profitable, you have a corporate tax rate of 35%.
Given the recent turmoil in the market, you asked your CFO to provide you with an updated estimate of the market risk premium. He told you that the market risk premium is 8%.
You also asked your CFO to give you an estimate of the market risk of your firm's equity using historic stock prices. He calculated a Beta (equity) for your firm of 1.1. The return on equity for your firm as a whole last year was 12.69%.
Project A is in your clothing division. This project will entail expanding your existing line of sports-related clothing. Your clothing division has been operated with its own cost of capital and capital structure. Historically, this division has been operated as 100% equity.
The VP of the clothing division has estimated the FCFs for years 1-5. (Please note, taxes have already been accounted for in these FCFs.) They are as follows:
| Year |
1 |
2 |
3 |
4 |
5 |
| FCF |
0 |
0 |
0 |
1200 |
2500 |
In addition, the VP estimates free cash flows will reach a steady state in year 6. She expects free cash flows to grow at a rate of 1.5% beginning after year 5. (In other words, year 6 FCF = 2500 * (1.015) ...)
It will cost $15,000 to invest in this project.
Additional information which may or may not be useful to solve this problem:
| Competitor |
Industries |
Debt beta |
Historic Equity beta |
Historic Debt/Value |
| Under Armor |
Clothing |
0 |
0.8 |
0.1 |
| Athletica |
Clothing |
0 |
1.2 |
0.4 |
| Puma |
Clothing and shoes and sports equipment |
0 |
1.6 |
0.5 |
(b) Now assume that all of the above information about the firm and the project still holds with the following exceptions: Assume the clothing division has NOT been operated as a 100% equity division. Instead the historic capital structure of this division has contained both debt and equity. And In keeping with this historic capital structure, the division estimates that this project should be funded by a mix of debt and equity. Specifically, the division plans to borrow $1000 at a cost of debt of 4%. If we include the interest tax shield benefits associated with $1000 in debt, what will be the total NPV of the project? Assume the debt is perpetual.