Corporate Finance Assignment

Valuation of a Firm

Show work in Excel file. In answering the questions of the assignment, make sure you spell out your assumptions, reason your arguments and conclusions, and support the arguments with financial analysis where possible. An answer may be considered incomplete without careful reasoning and supporting analysis.

1. Assume that a company is expected to produce EBIT of $150M in perpetuity. The corporate tax rate the company is subject to is 21%. To maintain the existing production capacities and support sales growth, capital expenditures are expected to be at $40M per year, in perpetuity. Annual depreciation, expected in perpetuity as well, is $30M. The current risk- free rate is 2%, and it is expected to remain so in perpetuity. The company has $120M in long- term debt, which is considered by the bank to be risk-free, so the interest rate the firm pays on its debt is 2%. The company expects to hold that amount of debt in perpetuity. Using stock returns on a comparable company that operates in the same industry, and has debt outstanding equal to 50% of the market value of its total capital, analysts estimated that the comparable company’s beta is 1.2. The analysts believe the companies are comparable in all respects except for the capital structure, and do not expect that beta to change over time. You also know that the estimate of the market risk premium for the foreseeable future is 5%. The firm has 10M common shares outstanding.

a)  Please calculate the value of the firm. You can use the Adjusted Present Value methodology, calculating the value of unlevered firm, and then adding the value of the tax shield due to debt. The assumption is that the costs of financial distress are zero, because debt is risk-free and the probability of default is zero.

b)  Please calculate the value of the firm’s equity.

Assume that the firm decided to issue additional debt in the amount of $100M. Also assume that the risk of the firm’s debt would not change due to the issuance of new debt.

c)  What do you expect the value of the firm’s equity to be if the company were to issue new debt and use the proceeds from this debt issue to repurchase equity?

d)  What price per share would the firm repurchase the equity at?

2. When preparing capital budgeting analysis for a new project, Chris Johnson, a chief financial officer at BT Industries, faced a dilemma. The project involved a production of new type of shipping containers, which were significantly more durable and had a considerably longer useful life compared to conventional containers used in the industry. The year was 2021, and the equipment necessary for producing the containers was being sold for $750K. Each year, this cost is expected to increase by 30%. The useful life of the equipment and the project is 6 years. Mr. Johnson estimated that during a recovery year, the project will generate net cash flows of $500K per year, while during a recessionary year, the project will lose money, with an expected net cash flow of $-100K per year.

Capital Budgeting Analysis for a New Project

Because the economy suffered a significant decline during the year, there was uncertainty about the economy in general, and, very much affected by the economy, the demand for shipping and containers. Market analysts predicted that 2022 provide certain information about the likelihood of recovery. At this point, in 2021, the likelihood of 2022 being a recovery year is estimated at 45% and the likelihood of 2022 being a recession year is estimated at 55%. If 2022 is a recovery year, the likelihood that recovery continues in 2023 and all subsequent years is 80%, and the likelihood of these subsequent years being recessionary years is 20%. If recession continues in 2022, the likelihood that 2023 and all subsequent years will be recovery years is 30%, and the likelihood of these subsequent years being recessionary is 70%. In 2023, the market gets resolved, and whatever state of the economy was in 2023 will continue the foreseeable future with certainty.

The management identified that they need to invest in the project in the next three years, or abandon it forever. That is, they were considering undertaking the investment in 2021, 2022, or 2023.

Mr. Johnson has estimated that the WACC for the company in certain times has been 10%. Assume that the project has no tax implications, i.e. the tax rate of 0%. Also assume that the firm can shut down the project any time at a one-time cost of $20K.

What strategy with respect to this investment will generate the highest value for the firm? In other words, when should the firm invest and under what circumstances?

To answer this question, a) evaluate the NPV of investing in 2021, in 2022, and in 2023, and b) carefully think about how you can combine the information obtained in these estimations to identify the most value-increasing strategy.

3. A firm is considering whether to finance a new project with debt or equity. The firm is real, so all the market imperfections are potentially present, including information asymmetries, agency costs, bankruptcy costs, taxes, uncertainty, etc.

a) Assume the firm has two alternatives with respect to financing of the project, debt or equity. That is, it can finance the new project fully with debt, or fully with equity. Will the choice of financing affect the WACC the firm uses to discount the project? If so, how?

b) Assume the firm is considering a project, and is thinking that if it takes the project, it would finance it with debt. Also assume that if it issues the debt, the increase in total firm value would equal the change in the present value of tax shield from the newly issued debt, because changes in the costs of financial distress and expected agency costs are small and can be disregarded. Should the firm incorporate the present value of the tax shield when calculating the NPV of the project and making their decision on whether to undertake the project? Why or why not?