Your firm is looking to expand into a new market segment that will require an initialcapital expenditure on new equipment of $4 million. The new division is expected tobegin generating revenues next year, forecast at $2.5 million, growing at 15% peryear for the first 3 years (Year 3 revenue will be 15% higher than year 2) and then 5%for the remaining 7 years of the project (year 4 revenue is expected to be 5% higherthan year 3 revenue). Operating costs are expected to be 75% of revenues and thecorporate tax rate is 35%. Assume that the project does not require any workingcapital. Also assume that the appropriate cost of capital for the project is 13%.a. If the equipment is depreciated straight-line over the ten year period and theequipment is expected to be worth nothing at the end of the ten years, would youproceed with the project? Show all calculations. Assume that your otherdivisions have sufficient taxable income to capture any tax refunds that may occurfrom negative taxable income on the project in the first couple years.b. Your accountant advises that you would be able to depreciate the equipmentstraight-line over the first five years due to accelerated depreciation rules thatwere enacted to encourage business spending. Assume that the equipment is stillexpected to have no salvage value at the end of the project. Would your decisionchange as a result of this new depreciation schedule? Show all calculations.c. In addition to being able to completely depreciate the asset over the first fiveyears of the project, your project manager believes that the firm will be able tosell the equipment for scrap value of $750,000 at the end of the ten years.(Assume that you will still fully depreciate the equipment over the first five yearsso that the book value of the equipment is zero when it is sold.) Under thisscenario, what is the NPV of the project?

Financial Management (BUSI 640) Problem Set #2 1. Your firm is looking to expand into a new market segment that will require an initial capital expenditure on new equipment of $4 million. The new division is expected to begin generating revenues next year, forecast at $2.5 million, growing at 15% per year for the first 3 years (Year 3 revenue will be 15% higher than year 2) and then 5% for the remaining 7 years of the project (year 4 revenue is expected to be 5% higher than year 3 revenue). Operating costs are expected to be 75% of revenues and the corporate tax rate is 35%. Assume that the project does not require any working capital. Also assume that the appropriate cost of capital for the project is 13%. a. If the equipment is depreciated straight-line over the ten year period and the equipment is expected to be worth nothing at the end of the ten years, would you proceed with the project? Show all calculations. Assume that your other divisions have sufficient taxable income to capture any tax refunds that may occur from negative taxable income on the project in the first couple years. b. Your accountant advises that you would be able to depreciate the equipment straight-line over the first five years due to accelerated depreciation rules that were enacted to encourage business spending. Assume that the equipment is still expected to have no salvage value at the end of the project. Would your decision change as a result of this new depreciation schedule? Show all calculations. c. In addition to being able to completely depreciate the asset over the first five years of the project, your project manager believes that the firm will be able to sell the equipment for scrap value of $750,000 at the end of the ten years. (Assume that you will still fully depreciate the equipment over the first five years so that the book value of the equipment is zero when it is sold.) Under this scenario, what is the NPV of the project? 2. Your firm has a new technology that will enable it to be the market leader in a new product segment. You estimate that the project life will be ten years, after which the project will cease operations. Your role is to determine the optimal size of the project as your analysis so far suggests that the larger the scope of the project, the lower will be the revenue growth rate. Specifically, you estimate that at nearly zero investment, the project will have a 30% growth rate but that for every $1 million invested in the project, the growth rate will drop by one percent. As an example, if $5 million is invested in the project, the estimated annual sales growth rate is forecast to be 25%. The other forecasts are as follows: Revenues begin in the first year after the initial investment and are equal in the first year to the amount of the initial investment (so if the investment is $5 million, expected revenue in year 1 is $5 million). Operating costs are estimated to be 85% of revenues. The investment can be fully depreciated straight-line over the ten-years and will have zero salvage value. The marginal tax rate is 35%. The project requires an investment in working capital in the first year equal to ten percent of the first year's expected revenues. In each year of operation, the working capital balance is expected to be ten percent of that year's revenue forecast. At the end of the project, the balance of working capital will be recovered. The estimated project cost of capital is 12%. What do you estimate to be the optimal size of the investment in the project? What is the NPV of the project at that investment level? Hint: Use Solver in Excel. 3. AK Associates is a management consulting firm focused on IT solutions in the Washington DC area. Their CFO is evaluating their capital structure as he looks to finance the firm's $100 million investment in additional systems hardware. As an IT firm, they have been extremely conservative in their financing to date, relying entirely upon equity to fund their previous investments. The CFO estimates that after the investment, the firm's worth one year from now will have the following dynamics, depending upon the state of the economy: State of Economy Probability Firm Value Poor Economy 20% $150 million Fair Economy 60% $200 million Good Economy 20% $250 million Because of the sensitivity of firm value to the economy, the CFO estimates the firm has an asset beta of 1. The current risk-free rate is 3.5%. Assume a market risk premium of 8.5%. a. If the firm finances the new investment with equity, what do you estimate to be the value of the equity today, just after the equity issuance? b. If the firm finances the new investment by issuing $100 million in one-year debt (assuming it is correctly priced), what do you estimate to be the value of the equity today? Does the fact that the equity value in (a) is more than the amount you estimated here mean that the firm should finance with equity instead of debt? Explain. c. If the shares are trading at $10 per share after raising the additional funds (equity in part (a), debt in part (b)), what do you estimate to be the value per share in each of the states of the economy for each of the capital structure choices? Assume that there are no capital structure frictions. Why is the average value higher if the firm issues debt instead of additional equity? 4. AK Associates does not operate in a perfect market. Now that the CFO has the perfect markets benchmark, he wants to incorporate frictions into his analysis that he knows AK will confront when raising capital. a. The firm faces a marginal corporate income tax rate of 35% and interest it pays on its debt is tax deductible whereas payments to equity holders are not. If the firm issues debt as contemplated in (1b), what is the value of the interest tax shield? If that debt were anticipated to be reissued perpetually, at the terms available in (1b), what it the value of this change in capital structure policy? (Assume that the tax benefit is the only friction, i.e. do not yet incorporate the friction in part b.) b. Even though the debt contemplated would not put the firm in jeopardy of default, the debt markets will still require a premium on corporate debt over what it will lend to the US government. If the debt market requires a 4.5% yield instead of the 3.5% risk-free rate but the interest is tax deductible and the equity market operates efficiently, is the firm better off issuing debt or equity? 5. General Mills is a food company which produces cereals, dessert mixes, and TV dinners. They just refinanced all of their outstanding debt by issuing $4.5 billion in debt. The debt is rated A by S&P and has a maturity of ten years. General Mills has 300 million shares outstanding and the current stock price is $50/share. The current one year government bond rate is 1.7% and the current ten year government bond rate is 3.4%. The expected market risk premium is 8.5%. a. The debt issue is a zero coupon bond with a face value of $6.5B which is due at maturity. What is the promised rate of return on the bond? b. Based upon the debt rating, assume the market is estimating a 10% probability that General Mills will not make the promised payment at maturity. The market believes bond holders will retrieve their initial $4.5 billion should the firm default at maturity but that none of the accrued interest will be paid. Since the bonds may default at maturity, they are risky. Describe the default risk associated with these bonds. Hint: If you hold the bonds until maturity what is your expected return? c. An examination of the equity returns of General Mills reveals an equity of 0.8. What is the cost of capital for the long term investments of General Mills? d. Laura Smith, the CFO of the dessert mix division, is evaluating an expansion opportunity and needs to determine the correct cost of capital for projects in her division. Although the dessert division's cash flows have low total variability, they are the most pro-cyclical of the three divisions. In other words they see the largest percentage increase in operating cash flow on average when the economy is expanding and the largest percentage decline on average in recessions. What can we say about the cost of capital that should be used in the dessert mix division