Question
You have been asked by your CFO to analyze the cash flow impacts from your firm temporarily shutting down one of its divisions due to
You have been asked by your CFO to analyze the cash flow impacts from your firm temporarily shutting down one of its divisions due to the covid pandemic. In particular, your firm has received a forgivable loan from the U.S. governments $660b Paycheck Protection Program (PPP) for $1M and has until May 14, 2020 (that is today for those of you who dont have your calendar in front of you--yes thats the real date) to return the loan if the firm cannot prove a sufficient illiquidity need for the loan. It is very important therefore to understand the cash flow impact from temporarily shutting down this division, or not temporarily shutting it down. If the division stays open, then your firm will keep the loan. If it decides to temporarily shut down the division, your firm will return the loan to the U.S. Treasury.
If the division remains open your firm gets to keep the $1M loan. Furthermore, you are very confident that you can meet the loan foregiveness requirements, so the loan becomes a $1M grant (i.e. you dont have to repay it). On the down side, if the division remains open you will incur incremental operating cash flow losses. You predict large (after-tax) incremental free cash flow reductions of $60,000 per month starting one month from now and continuing for a total of 6 months. After that time, you forecast a perpetual 5% per month decline in these incremental free cash flow losses as the economy recovers.
Your firm faces a 21% Federal and 8.84% California marginal tax rate. You forecast a 0% monthly T-bill rate and a 0.5% monthly rate for the market risk premium. Your equity beta estimate is very high at 2.50 due to your firms high debt ratio of 75%. (The firm has borderline liquidity problems, thus the ability to qualify for the PPP loan.) The firms borrowing rate is approximately 1% per month.
a) Given this information, what is your estimate of the firms weighted average cost of capital?
r_wacc = _______________
b) What is your estimate of the NPV of the decision to keep this division open?
NPV = _______________
c) Based on this analysis, should your firm shut down this division?
d) Your CFO asks you Which two variables in this analysis are the most important, and why? What do you think are the two most sensitive variables in this analysis, and why? (This answer calls for qualitative judgement as you have to answer immediately on the spot and dont have any time to numerically investigate the answer
this is one of the final questions for intermediate finance, I post it as it is
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