Your friend is looking to launch a new hotel chain, Roxy Inc., designed to serve the traveling needs of the budget-minded millennial traveler.

To launch Roxy Inc., she is expected to invest $500 million this year (year=0). The hotel chain is expected to generate free cash flows of $27 million per year, starting in year 1. Thereafter, these free cash-flows are expected to grow at 3 percent per year in perpetuity. For simplicity, assume these cash-flows are received at the end of each year.

Your friend knows youve been taking this class, so she asked you to assess the potential value of the new hotel chain. To help you, she gives you the following reports for a handful of publicly-traded firms, as well as the expected returns on the government bond (Treasury), and the risk premium on the value-weighted market portfolio:

Company Dropbox Ikea Intercontinental Hotels Group

Market Value of Equity 900 1,000 7,500

Market Value of Debt

150

100

2,500

equity beta:

2

2.3

1.6

10-year Treasury rate - 2.0%

Expected Market Risk Premium - 5.0%

Assume throughout that the CAPM holds for all assets, and that the debt of Dropbox, Ikea, and Intercontinental Hotel Group is risk-free. None of these firms hold (excess) cash assets.

If Roxy Inc. were to be 100% equity financed, what would be a reasonable estimate of the expected return on Roxys equity? What is Roxys WACC?

The estimated value of Roxy Inc. is: ____________ The estimated gain to your friend from investing in Roxys Inc. is: ____ Is the investment worth pursuing (Yes/No) ______

Assume now that the new hotel chain is financed instead with a debt-to-value ratio of 25%, and that this leverage ratio is not expected to change over time. What is Roxys WACC? What is its cost of equity? What is the value of Roxy? In this part, assume that the debt issued is risk-free and that there are no frictions in financial markets (no taxes, bankruptcy costs, etc).

Roxys WACC with leverage is: ________ Roxys return on equity: _______ The value of Roxy Inc. is now: ______ Is the investment worth pursuing (Yes/No) ______

(d) After you complete your analysis in part (c), you learn that Roxy does actually pay a corporate tax of 35%. Describe the effect of corporate taxes on (i) Roxys WACC and (ii) Roxys expected value. [10 marks]