Solutions-Chapter18

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Chapter 18: Capital Budgeting and Valuation with Leverage
18-1. Explain whether each of the following projects is likely to have risk similar to the average risk of the firm.
a. The Clorox Company considers launching a new version of Armor All designed to clean and protect notebook computers.
b. Google, Inc., plans to purchase real estate to expand its headquarters.
c. Target Corporation decides to expand the number of stores it has in the southeastern United States.
d. GE decides to open a new Universal Studios theme park in China.
a. While there may be some differences, the market risk of the cash flows from this new product is likely to be similar to Clorox’s other household products. Therefore, it is reasonable to assume it has the same risk as the average risk of the firm.
b. A real estate investment likely has very different market risk than Google’s other investments in Internet search technology and advertising. It would not be appropriate to assume this investment has risk equal to the average risk of the firm.
c. An expansion in the same line of business is likely to have risk equal to the average risk of the business.
d. The theme park will likely be sensitive to the growth of the Chinese economy. Its market risk may be very different from GE’s other divisions, and from the company as a whole. It would not be appropriate to assume this investment has risk equal to the average risk of the firm.
18-2. Suppose Caterpillar, Inc., has 665 million shares outstanding with a share price of $74.77, and $25 billion in debt. If in three years, Caterpillar has 700 million shares outstanding trading for $83 per share, how much debt will Caterpillar have if it maintains a constant debt-equity ratio?
E = 665 million × $74.77 = $49.7 billion, D = $25 billion, D/E = 25/49.722 = 0.503. E = 700 million × $83.00 = $58.1 billion.
Constant D/E implies D (= E x D/E) = 58.1 × 0.503 = $29.2 billion.
18-5. Suppose Goodyear Tire and Rubber Company is considering divesting one of its manufacturing plants. The plant is expected to generate free cash flows of $1.5 million per year, growing at a rate of 2.5% per year. Goodyear has an equity cost of capital of 8.5%, a debt cost of capital of 7%, a marginal corporate tax rate of 35%, and a debt-equity ratio of 2.6. If the plant has average risk and Goodyear plans to maintain a constant debt-equity ratio, what after-tax amount must it receive for the plant for the divestiture to be profitable?
We can compute the levered value of the plant using the WACC method. Goodyear’s WACC is
rwacc  1 8.5% 2.6 7%(10.35)5.65%. 12.6 12.6
See class notes for calculating D/(E+D) and E/(E+D). Therefore, VL  1.5  $47.6 million
0.0565  0.025
A divestiture would be profitable if Goodyear received more than $47.6 million after tax.

18-6. Suppose Alcatel-Lucent has an equity cost of capital of 10%, market capitalization of $10.8 billion, and an enterprise value of $14.4 billion. Suppose Alcatel-Lucent’s debt cost of capital is 6.1% and its marginal tax rate is 35%.
a. What is Alcatel-Lucent’s WACC?
b. If Alcatel-Lucent maintains a constant debt-equity ratio, what is the value of a project with average risk and the following expected free cash flows?
a. rwacc 10.810%14.410.86.1%(10.35)8.49% 14.4 14.4
b. Using the WACC method, the levered value of the project at date 0 is
VL 50  100  70 185.86. 1.0849 1.08492 1.08493
Given a cost of 100 in Year 0 to initiate the project, the project’s NPV is 185.86 – 100 = 85.86.
18-13. Prokter and Gramble (PKGR) has historically maintained a debt-equity ratio of approximately 0.20. Its current stock price is $50 per share, with 2.5 billion shares outstanding. The firm enjoys very stable demand for its products, and consequently it has a low equity beta of 0.50 and can borrow at 4.20%, just 20 basis points over the risk-free rate of 4%. The expected return of the market is 10%, and PKGR’s tax rate is 35%.
a. This year, PKGR is expected to have free cash flows of $6.0 billion. What constant expected growth rate of free cash flow is consistent with its current stock price?
a. E=$50×2.5B=$125B D = 0.20 × 125 B = $25 B VL =E+D=$150B
From CAPM: Equity Cost of Capital = 4% + 0.5(10% – 4%) = 7% WACC = (125 / 150) 7% + (25 / 150) 4.2% (1 – 35%) = 6.29%
VL
L FCF FCF 6
V  g=rwacc – rWACC g
=0.0629– =0.0229=2.29% 150

18-15. Remex (RMX) currently has no debt in its capital structure. The beta of its equity is 1.50. For each year into the indefinite future, Remex’s free cash flow is expected to equal $25 million. Remex is considering changing its capital structure by issuing debt and using the proceeds to buy back stock. It will do so in such a way that it will have a 30% debt-equity ratio after the change, and it will maintain this debt-equity ratio forever. Assume that Remex’s debt cost of capital will be 6.5%. Remex faces a corporate tax rate of 35%. Except for the corporate tax rate of 35%, there are no market imperfections. Assume that the CAPM holds, the risk-free rate of interest is 5%, and the expected return on the market is 11%.
a. Using the information provided, complete the following table:
a. Before the change:
FromtheCAPM,rE 5%1.506%14%
Since the firm has no leverage, r  r  r 14% . wacc U E
After the change:
r r D(r r )
EUEUD
rE 14%0.30(14%6.5%)16.25%.
Since the firm has D/E of 0.30, the WACC formula is ED
r r r(1T) wacc DE E DE D C
1 0.3
 1.3 16.25%  1.3 6.5%(1  0.35)
 13.475%.