Question: 
Example:
You are a consultant who has been hired to evaluate a new product line for Markum Enterprises. The upfront investment required to launch the product line is $9 million. The product will generate free cash flow of $0.73 million the first year, and this free cash flow is expected to grow at a rate of 3% per year. Markum has an equity cost of capital of 11.4%, a debt cost of capital of 5.07%, and a tax rate of 26%. Markum maintains a debt-equity ratio of 0.70 . a. What is the NPV of the new product line (including any tax shields from leverage)? b. How much debt will Markum initially take on as a result of launching this product line? c. How much of the product line's value is attributable to the present value of interest tax shields? a. What is the NPV of the new product line (including any tax shields from leverage)? We can use the WACC method to calculate the levered value of the project. To calculate the WACC, use the following formula: rwacc=E+DErE+E+DDrD(1+c) where E= market value of equity D= market value of debt c= marginal corporate tax rate rE= equity cost of capital rD= debt cost of capital Therefore, rwacc=1+0.7510.122+1+0.750.750.0732(10.20)=0.0948=9.48% Markum's WACC is 9.48%. To compute the levered value of the investment, use the following formula: VL=rwaccgFCF Therefore, VL=0.09480.02$0.85million=$11.36million To calculate the NPV, use the following formula: NPV=Investment+Leveredvalue Therefore, NPV=$4million+$11.36million=$7.36million The NPV of the new product line is $7.36 million. b. How much debt will Markum initially take on as a result of launching this product line? To compute the initial debt, use the following formula: Dt=dVtL where Dt= incremental debt of project on date t d= debt-to-value ratio VLt= value of levered investment at date t Therefore, D0=0.4286$11.36million=$4.87million Debt will be $4.87 million. c. How much of the product line's value is attributable to the present value of interest tax shields? Discounting at rU gives unlevered value. To calculate the unlevered cost of capital (rU), use the following formula: rU=E+DErE+E+DDrD=PretaxWACC where E= market value of equity D= market value of debt rE= equity cost of capital rD= debt cost of capital Therefore, rU=1+0.7510.122+1+0.750.750.0732=0.1011=10.11% Markum's unlevered cost of capital is 10.11%. To compute the unlevered value, use the following formula: VU=rugFCF Therefore, VU=0.10110.02$0.85million=$10.48million The unlevered value of the project is $10.48 million. To determine the tax shield, use the following formula: Taxshield=VLVU Therefore, Taxshield=$11.36million$10.48million=$0.88million The amount of the product line's value that is attributable to the present value of interest tax shields is $0.88 million
