The following spreadsheet presents the cash flow associated with a new proposed project by your firm. First, you thought
Posted: Sat May 14, 2022 3:39 pm
The following spreadsheet presents the cash flow associated with
a new proposed project by your firm. First, you thought of using
the Free Cash Flow-to-equity (FCFE) valuation method and
discounting the cash flows using the company’s equity cost of
capital of 11% to see if the project has a positive NPV. The
required capital expenditure for the project is $200 million and
the required NWC is $40 million. While the project’s risk is
similar to the firm’s, the project’s incremental leverage is very
different from the company’s historical debt-equity ratio of 0.20:
For this project, the company will instead borrow $160 million
upfront and repay $40 million in year 2, $40 million in year 3, and
$80 million in year 4. Thus, the project’s equity cost of capital
is likely to be higher than the firm’s, not constant over
time—invalidating the use of FCFE method. Clearly, the FCFE
approach is not the best way to analyze this project. You figured
that you can use a better method to value this project. a. What is
the present value of the interest tax shield associated with this
project? b. What are the free cash flows to firm (FCFF) of the
project? c. Compute the Adjusted Present Value (APV) of this
project. d. What is the best estimate of the project’s value from
the information given?
a new proposed project by your firm. First, you thought of using
the Free Cash Flow-to-equity (FCFE) valuation method and
discounting the cash flows using the company’s equity cost of
capital of 11% to see if the project has a positive NPV. The
required capital expenditure for the project is $200 million and
the required NWC is $40 million. While the project’s risk is
similar to the firm’s, the project’s incremental leverage is very
different from the company’s historical debt-equity ratio of 0.20:
For this project, the company will instead borrow $160 million
upfront and repay $40 million in year 2, $40 million in year 3, and
$80 million in year 4. Thus, the project’s equity cost of capital
is likely to be higher than the firm’s, not constant over
time—invalidating the use of FCFE method. Clearly, the FCFE
approach is not the best way to analyze this project. You figured
that you can use a better method to value this project. a. What is
the present value of the interest tax shield associated with this
project? b. What are the free cash flows to firm (FCFF) of the
project? c. Compute the Adjusted Present Value (APV) of this
project. d. What is the best estimate of the project’s value from
the information given?