Problem 1:

You are thinking of starting a firm that manufactures electronic medical devices.The required capital investment in plant and equipment is $20,000,000.00.After your manufacturing facility is completed, you estimate that the firm will generate an average return on investment before interest and taxes (EBIT) of 15 percent each year.However, each year's EBIT is risky because it will vary from year to year depending upon economic conditions in the medical equipment industry.For present value calculations, assume that the EBIT is realized at the end of each year starting with the first cash flow being received at t = 1.The risk-free rate is .035.The stakeholders of the firm have personal tax rates T_S = T_B = .15.The corporate tax rate is .28.You have looked at other small electronic medical device manufactures that have similar products and assets.MedEDev Inc, in particular, is very similar to your proposed firm.Below is the data on MedEDev Inc.

Value of Debt, B $20,000,000

Value of Equity, S $10,000,000

Shareholders personal tax rates

Dividend and Capital Gains Rate.15

Interest Income.15

Corporate Tax Rate.28

Expected Return on Equity .12

Yield on Debt .065

Expected Return on the Market .20

a.If you fund your firm by issuing only equity, what is a good estimate of the required rate of return for your firm's equity (i.e., the assets of your unlevered firm)? One approach is to take the information for MedEDev. Inc. and, using the relationship implied by Miller and Modigliani Proposition II between the required rate of return in equity, the required rate of return on assets, the required rate of return on debt, and the values of debt and equity, infer the required rate of return on assets from the market data on a firm that faces similar risk.More precisely, recall that M&M II states that

R_S=R_A+(1-T_C)(B/S)(R_A-R_B),

where is the required rate of return in equity (i.e., stock), is the required rate of return on the assets (or the equity of an all-equity firm), is the required rate of return on debt (i.e., bonds), is the value of the debt, is the value of the equity, and is the corporate tax rate.For MedEDev, there is information on everything other than , which you would like to infer (so that you can apply it to determine if the present value of the cash flows generated by your facility exceeds the present value of its costs (in this case, the $20,000,000 you are thinking about investing now). An algebraic manipulation of the M&M II proposition equation allows us to expressas a function of the observable market variables (that is, we can infer the value of from the variables we can directly observe).Specifically,

R_S=R_A+(1-T_C)(B/S)(R_A-R_B)

R_S=R_A [1+(1-T_C )(B/S)]-(1-T_C )(B/S)R_B

R_S+(1-T_C )(B/S)R_B=R_A [1+(1-T_C )(B/S)]

R_A=(R_S+(1-T_C )(B/S)R_B)/(1+(1-T_C )(B/S) )

That is, the last line shows as a function of , , , , and .This equation essentially delevers the required rate of return (it undoes the effect of leverage on the required rate of return on equity).

Using this last equation, what is an estimate of the required rate of return for MedEDev's asset?

b.Using the estimate of the required rate of return on assets derived from MedEDev (i.e., your answer to a above), what will be the value of your unlevered firm?The value is the net present value (the difference between the present value of the future cash flows and the cost of the investment, which is $20,000,000 in this case).Note that the present value of the cash flows is the present value of a perpetuity, where the discount rate is the rate inferred in part a above. For the expected future cash flows, don't forget corporate taxes.

c.If you fund your firm solely with equity, what does the estimate of the net present value form b above indicate?Should you go forward with your idea or not?Why?

d.Are there any concerns you have about the estimate of the required rate of return on assets implied from MedEDev as applied to the all-equity firm you manage?Given your concerns, is the estimated required rate of return biased too high or low?Which?And how might that affect your decision to invest $20,000,000?