Ports, Ltd. is a partnership of two college friends that want to develop a new algorithm for ports management to be sold to shipping companies. They spent €25,000 researching and collecting intelligence before deciding to go ahead with this project. The partnership’s business model is characterized by starting up the project and, after 6 years, selling it to other investors or through an initial public offering (IPO). The expected market value would be €2,050,502, considering it is fully financed by equity. The two college friends have not decided yet on how to finance it. They are considering the pros and cons of the financing mix for the company. Scenario 1 is to issue 1 million shares worth €1 each, and no debt at all. Nevertheless, because they are so confident about the project, another scenario Scenario 2 is to finance the project through bank borrowing. They expect to maintain an outstanding balance on the loan at 1 million euros. In this case, CaliforniaPorts only needs to have the initial equity of €10.000 (but still 1 million shares, i.e., a book value per share equal to €0,01). Scenario 3 could be a mix of equity and debt. Consequently, if a project is financed through debt, the likelihood of a default increases. The estimated costs of financial distress are 20% of the unlevered market value of the company. The founders assume it can borrow from local banks at 6.25% if the risk of default is mild. The two college friends are well aware that two categories of corporate debt ratings exist. The different levels inside each category represent the likelihood of default. Highly indebted companies tend to have ratings among the lowest. The average junk bond spread over equivalent maturity risk-free bonds was 650 basis points over the past year. Current economic data shows that the medium-term average risk-free rate is 2.25%, and the expected market risk premium is 6.50%. However, some researchers have been using, for the software industry, a weighted average beta of 1.275 with a debt-to-equity ratio of 0.125. They also assume that debt betas are generally small, and simplify it to be riskless. The corporate tax rate is 25%.

Questions about Scenario 1

a) What is CaliforniaPorts’ equity cost of capital?

b) What is CaliforniaPorts’ value per share?

Questions about Scenario 2

c) What is CaliforniaPorts’ present value of interest tax shield?

d) Assume the personal taxes are 28% on interest and 28% on equity return.

What is the tax advantage in the presence of personal taxes? Explain.

e) What is CaliforniaPorts’ value if the risk of default is absent from your analysis?

f) What is CaliforniaPorts’ present value of financial distress costs?

g) What is CaliforniaPorts’ value, including the risk of default?

Questions about Scenario 3

h) The software industry has an average debt-to-equity ratio of 0.125. What do you think about such level of debt-to-equity ratio for the industry? Explain.

i) If CaliforniaPorts follows its economic sector financing mix, what would be its value?

j) What is CaliforniaPorts’ equity per share?