Question 3 [25 points] Company ABC with market value of $600 million has a leverage given by D/E = 0.5 (also in market values). The current cost of equity is given by re = 19%, and cost of debt is given by rp = 7%. The corporate tax rate (Tc) is equal to 40%. a. Determine the return on assets (ra) of the company, and its WACC. Explain the difference in one sentence. The company wants to decrease the WACC by changing the leverage, but also agrees that the cost of equity should not become higher than 30%. b. Determine the lowest possible WACC, given this constraint, under the assumption that the cost of debt rp is not changed by leverage. Also determine the corresponding leverage. c. Make a sketch of rA and WACC as function of leverage (D/E) that is in line with the given information, and locate the answers of part a and b in your sketch. Also reflect in your sketch that for extreme leverage, higher than your answer in part b, the costs of financial distress start to increase. [Remark: the rest of question 3 does not depend on your answers in part b and c] The company considers to invest in a project with an expected (after tax) cash flow stream of $100.000 in year 1, growing with 3% each year. d. Determine the Net Present Value (NPV) of the project, assuming it is a carbon copy of the firm, with leverage of the firm as initially given, so with D/E = 0.5. e. Show how the same value can be derived, quite accurately, as an Adjusted Present Value (APV). Briefly comment on the assumptions underlying your APV calculation. Question 3 [25 points] Company ABC with market value of $600 million has a leverage given by D/E = 0.5 (also in market values). The current cost of equity is given by re = 19%, and cost of debt is given by rp = 7%. The corporate tax rate (Tc) is equal to 40%. a. Determine the return on assets (ra) of the company, and its WACC. Explain the difference in one sentence. The company wants to decrease the WACC by changing the leverage, but also agrees that the cost of equity should not become higher than 30%. b. Determine the lowest possible WACC, given this constraint, under the assumption that the cost of debt rp is not changed by leverage. Also determine the corresponding leverage. c. Make a sketch of rA and WACC as function of leverage (D/E) that is in line with the given information, and locate the answers of part a and b in your sketch. Also reflect in your sketch that for extreme leverage, higher than your answer in part b, the costs of financial distress start to increase. [Remark: the rest of question 3 does not depend on your answers in part b and c] The company considers to invest in a project with an expected (after tax) cash flow stream of $100.000 in year 1, growing with 3% each year. d. Determine the Net Present Value (NPV) of the project, assuming it is a carbon copy of the firm, with leverage of the firm as initially given, so with D/E = 0.5. e. Show how the same value can be derived, quite accurately, as an Adjusted Present Value (APV). Briefly comment on the assumptions underlying your APV calculation
