F2 Q18

For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other. This is the assumption we made in most of the videos to focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

You are working on a big new idea for your firm. You have projected an EBIT of $5 million starting next year (t = 1) with a growth rate of 3.50% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. Your firm will consider all types of financing options, but the first critical step in your analysis is figuring out the present value of the cash flows of the new business. Your research has revealed the following information: similar businesses have a beta asset of 2.00, the risk-free rate is 2.00% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 3.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You are tasked to figure out the value of the business under various financing alternatives, including long-term loan/debt. You have considered a loan of $25 million in perpetuity at an interest rate of 4%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you decide to take on $25 million of debt in perpetuity. The return on equity from t = 0 to t = 1 will be (Enter the number in percentage terms with up to two decimals but no % sign.):