XYZ  is a firm, which operates 10 coal mines in Wales. It has total assets of  $500m and the value of its shares is $900m. XYZ ’s directors perceive a great opportunity in the Maldives government’s privatization drive. They have held preliminary discussions with the government about the purchase of the 25 coal mines in Maldives. The purchase price suggested by the Treasury is $2,500m.  For two months, the directors have decided to use $1500m of equity capital (retained earnings and new issue) and $1000m from perpetual coupon bonds. The firm is in 40% tax bracket. Current investigation has gathered the following data:

Debt: The firm can raise an unlimited debt by selling $1,000 par value perpetual bonds at 10% coupon rate, on which annual interest payments will be made. To sell the issue, an average discount of $30 per bond must be given. The firm must also pay flotation costs of $20 per bond.

Common stock:   The firm’s common stock is currently selling for $90 per share. The firm expects to pay cash dividend of $8 per share next year. The firm’s dividends have been growing at an annual rate of 6%, and this rate is expected to continue in the future. The stock will have to be underpriced by $4 per share, and flotation costs are expected to be $4 per share. The firm can sell an unlimited amount of new common stock under these terms.

Retained earnings:  The firm expects to have $250m of retained earnings available in the coming year. Once these retained earnings are exhausted, the firm will use new common stock as the form of equity financing.

You are a senior analyst and last week you listened attentively to XYZ’s presentation. You were impressed by their determination; acumen and track record but have some concerns about their figures for the new project. 

XYZ’s projections are as follows, excluding the cost purchasing the mines (all the following cash flows are after tax): 

Table 1: Cash flows for the English coal mines: XYZ’s estimate
Time t	1	2	3	4	5 and thereafter
Sales ($Million)	5000	10% higher than Year 1	8% higher than Year 2	6% higher than Year 3	5% growth in each year
Operating costs ($Million)	4500	5% higher than Year 1	5% higher than Year 2	5% higher than Year 3	5% growth in each year

You believe the probability of XYZ’s projection being correct to be 50 percent (or 0.5). You also estimate that there is a chance that XYZ’s estimates are over-cautious. There is a 30 percent probability of the cash flows being as shown in Table 2 (excluding the cost of purchasing the mines).

Table 2: A more optimistic forecast
Time t	1	2	3	4	5 and thereafter
Sales ($Million)	3000	15% higher than Year 1	13% higher than Year 2	12% higher than Year 3	8% growth in each year
Operating costs ($Million)	2500	8% higher than Year 1	8% higher than Year 2	8% higher than Year 3	8% growth in each year

On the other hand, events may not run out as well as XYZ’s estimates. There is 20 percent probability that the cash flows will be shown in Table 3.

Table 3:  A more pessimistic scenario
Time t	1	2	3	4	5 and thereafter
Sales ($Million)	2000	6% higher than Year 1	5% higher than Year 2	4% higher than Year 3	3% growth in each year
Operating costs ($Million)	1200	3% higher than Year 1	3% higher than Year 2	3% higher than Year 3	3% growth in each year

 

Assume that cash flow will arise at year-ends except the initial payment to the government, which occurs at Time 0.

1. Calculate the expected net present value (NPV) and the standard deviation of the NPV for the project to buy the Maldives coal mines if $2500m is taken to be the initial cash outflow.