QUESTION 1: IKEA has made a booming business out of selling prefabricated furniture. Now, it is looking to launch a new hotel chain, Moxy Inc., designed to serve the budget-minded traveler. To launch Moxy Inc., IKEA is expected to invest $490 million today (year (). The hotel chain is expected to generate free cash flows of $24 million per year, starting at the end of the first year (year 1). Thereafter, these free cash flows are expected to grow at 3 percent in perpetuity. For simplicity, assume these cash flows are received at the end of each year. You are asked to assess the potential value of the new hotel chain. Since you are pressed for time, you ask Gran Lf, your assistant, to help you gather financial data. Gran reports recent financial data for a couple of publicly-traded firms, as well as the expected returns on Treasuries, and the risk premium on the value-weighted market portfolio: Company La-Z-Boy Furniture Inc. Intercontinental Hotels Group Market Value Market Value of of Equity Debt 1,000 7,500 2,700 Excess Cash 50 200 100 Equity Beta 2.3 1.6 10-year Treasury rate 2.0% Expected Market Risk Premium 5.0% Both companies in the table above had constant leverage ratios in the past, and their debt is highly rated for both. Excess cash denotes cash the firms have but do not use in their operations. Assume throughout that the CAPM holds for all assets. (a) If Moxy Inc. is 100% equity financed, what is a reasonable estimate of the required rate of return on Moxy's equity? What is Moxy's WACC? (b) What is the value of launching Moxy Inc.? Is the project worth pursuing? (c) Assume now that the new hotel chain is instead financed with a debt-to-value ratio of 25%, and that this leverage ratio is not expected to change over time. The debt issued is risk-free, and there are no frictions in financial markets other than the tax benefits of corporate debt. With a corporate tax rate of 35%, what is Moxy's WACC? What is the value of Moxy? (d) After you complete your analysis in part (c), you learn that, due to various investment tax credits, the effective tax rate that Moxy faces will only be 15%, not 35% as you had originally forecasted. Without doing any further calculations, briefly describe the effect of this change on (i) Moxy's WACC and (ii) Moxy's expected value compared to part (c). QUESTION 1: IKEA has made a booming business out of selling prefabricated furniture. Now, it is looking to launch a new hotel chain, Moxy Inc., designed to serve the budget-minded traveler. To launch Moxy Inc., IKEA is expected to invest $490 million today (year (). The hotel chain is expected to generate free cash flows of $24 million per year, starting at the end of the first year (year 1). Thereafter, these free cash flows are expected to grow at 3 percent in perpetuity. For simplicity, assume these cash flows are received at the end of each year. You are asked to assess the potential value of the new hotel chain. Since you are pressed for time, you ask Gran Lf, your assistant, to help you gather financial data. Gran reports recent financial data for a couple of publicly-traded firms, as well as the expected returns on Treasuries, and the risk premium on the value-weighted market portfolio: Company La-Z-Boy Furniture Inc. Intercontinental Hotels Group Market Value Market Value of of Equity Debt 1,000 7,500 2,700 Excess Cash 50 200 100 Equity Beta 2.3 1.6 10-year Treasury rate 2.0% Expected Market Risk Premium 5.0% Both companies in the table above had constant leverage ratios in the past, and their debt is highly rated for both. Excess cash denotes cash the firms have but do not use in their operations. Assume throughout that the CAPM holds for all assets. (a) If Moxy Inc. is 100% equity financed, what is a reasonable estimate of the required rate of return on Moxy's equity? What is Moxy's WACC? (b) What is the value of launching Moxy Inc.? Is the project worth pursuing? (c) Assume now that the new hotel chain is instead financed with a debt-to-value ratio of 25%, and that this leverage ratio is not expected to change over time. The debt issued is risk-free, and there are no frictions in financial markets other than the tax benefits of corporate debt. With a corporate tax rate of 35%, what is Moxy's WACC? What is the value of Moxy? (d) After you complete your analysis in part (c), you learn that, due to various investment tax credits, the effective tax rate that Moxy faces will only be 15%, not 35% as you had originally forecasted. Without doing any further calculations, briefly describe the effect of this change on (i) Moxy's WACC and (ii) Moxy's expected value compared to part (c)
