Tablet Company is looking to set up a wholly owned subsidiary firm. The firm, which will require an initial capital expenditure of $900M, will sell cheap, rugged computers in developing countries. The debt schedule for the project is predetermined and shown below for years 0, 1, and 2. After year 2, the project will maintain a fixed level of debt equal to 700. The free cash flows of the project for years 0 to 2 are as follows:

Assume that after year 2 the FCFs grow at a rate of 3% each year. The unlevered cost of capital is 17%, the return on debt is 8%, and the tax rate is 40%. Assume that the free cash flows above occur during the year, while in the following questions the value of the firm is as of the end of the year. 2

(a) Calculate the terminal value of the project as of year 2. Be sure to include the value of the tax shield in your calculations.

(b) Use the Adjusted Present Value (APV) method to calculate the levered value of the firm as of the end of year 0 and year 1.

(c) What is the value of the firms equity at the end of years 0, 1, and 2?

(d) Using your answers from the previous parts, what is the cost of equity capital at the end of years 0, 1, and 2?

(e) Calculate the after-tax WACC for each year.

(f) Now re-calculate the total value of the firm at the end of years 0, 1, and 2 by discounting the subsequent free cash flows/firm values using the after-tax WACC. You may use your answers from the previous parts as inputs into your calculations. Why are your answers different from parts (a) and (b)? Which method would be correct to use in this situationAPV or after-tax WACC?

Year 0 1 2 FCF -900 150 200 Debt 900 800 700