Question
T. Holdings, an Asia-Pacific telecommunications company, has excess capital and is looking to make a regional telecommunications investment. S. Corp won the contract to advise
T. Holdings, an Asia-Pacific telecommunications company, has excess capital and is looking to make a regional telecommunications investment. S. Corp won the contract to advise T. Holdings on the potential of the investment, and allows T. Holdings to pay for its charges in annual installments, starting at $2 million for the next year, and increasing at 10% annually until the final installment in the fifth year.
The project under consideration entails an initial infrastructural investment of $600 million, and subsequent investments of the same amount every five years. These assets will be depreciated on a straight-line basis to a book value of zero five years from the purchase, but can be salvaged for approximately half the original investment amount. Revenue for the next year is projected to be $800 million, and is expected to grow at an annual rate of 20% for four years (i.e., years 2 through 5), after which revenues are expected to remain at that level indefinitely. Annual variable costs and year-end net working capital associated with the project are estimated to be 30% and 10% of annual revenue respectively, and fixed costs are estimated to be $80 million per year.
Neither the debt nor equity of T. Holdings is traded, but S. Corp reckons they are worth $3 billion and $6 billion respectively. In the immediate future, T. Holdings intends to recapitalize by issuing equity to repay all of their outstanding debt. In addition, S. Corp looked into Good Inc. and Bad Inc.?the former is a conglomerate with businesses such as global telecommunications, food and beverage, and financial services, whereas the latter is a pure-play which focuses on developing their telecommunications business in the AsiaPacific. Also, S. Corp provides the following information on these entities:
The prevailing corporate marginal tax rate is 20%, the expected return on the market portfolio is 15%, and the risk-free rate is 5%. Assume the firm?s cost of debt does not vary with capital structure and financial distress is costless.
(i) Calculate and justify a suitable weighted average cost of capital based on T. Holdings? existing capital structure.
(ii) Justify and calculate a suitable discount rate for the telecommunications project.
Good Inc. Beta Market value of equity Market value of debt Face value of debt Years to debt maturity Annual coupon rate Bad 1.80 $10 billion $20 billion $22 billion 15 10% Inc 1.20 $4 billion $2 billion $2.2 billion 5
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