DUKE UNIVERSITY Fuqua School of Business FINANCE 351 - CORPORATE FINANCE Problem Set #5 Prof.

Simon Gervais Questions 1. Digital Organics (DO) has the opportunity to invest $1 million now (t = 0) and expects after-tax returns of $600,000 in t = 1 and $700,000 in t = 2. The project will last for two years only. The appropriate cost of capital is 12% with all-equity nancing, the borrowing rate is 8%, and DO will borrow $300,000 against the project. This debt must be repaid in two equal installments. Assume that debt tax shields have a net value of $0.30 per dollar of interest paid. Calculate the projects APV. 2. Environmentally Correct Inc. is considering a project to make solar water heaters. The water heater project requires an investment of $25 million and oers a steady after-tax cash ow of $4.5 million per year for 10 years. The required return on unlevered cash ows is 12%. Environmentally Correct is going to nance this project with a $12.5 million debt issue that is privately placed. This debt issue has an interest rate of 8%. The remaining $12.5 million will be raised from equity capital. The debt principal of $12.5 million is to be paid back in ten equal installments. Assume the marginal tax rate for corporations is 34%. Calculate the APV of the project. 3. Assuming all equity nancing, a project has a net present value (NPV) of $1.5 million. To nance the project, debt is issued with associated oatation costs of $60,000. The oatation costs can be amortized over the projects 5 year life. The debt of $10 million is issued at 10% interest, with principal repaid in a lump sum at the end of the fth year. If the rms tax rate is 34%, calculate the projects adjusted present value (APV). 4. The Sretaw Regor (SR) Corporation is considering a new 5-year project. Since this project is very dierent from SRs current operations, the adjusted present value will be used to value the project. The project requires an initial investment of $750,000 in new assets, which will be depreciated straight-line to 0 over the projects 5-year life. These assets will be worthless in ve years, i.e., they will not be resold. Each year for ve years, the project is expected to generate pre-tax revenues of $600,000 and to require pre-tax costs of $240,000. The entire project will be nanced through a 5-year bank loan with an annual rate of 10%. The principal on the loan will be repaid in equal installments of $150,000 each (i.e., each year, the company pays $150,000 in principal, and pays the interest on the outstanding loan). It is estimated that the pre-tax costs (payable at time zero) of negotiating the loan will be 4% of the amount borrowed. The projects risk is very similar to the risk of Ruomlig Divad (RD) Inc.s (unlevered) assets. This rm is currently nanced by 100,000 shares worth $12.50 each, and $750,000 worth of debt. The beta of RDs stock is 1.5, and the company borrows at a rate of 11%. 1 Fall 2011 Term 2

The riskfree rate in the economy is 8%, and the expected return on the market is 18%. The current corporate tax rate is 45% (assume that it applies to both SR and RD). Ignore personal taxes, and assume that the debt of all the rms is permanent (i.e., not rebalanced). (a) What is the appropriate discount rate for the unlevered project? (b) What is the adjusted present value of the project?
(Optional)

5. You are asked to value the equity of Roberts Corporation, a company that started to manufacture melamine particle boards. The capital cost of the project is $10 million in year 0. The melamine project will generate the following operating cash ows (in million dollars) before interest and taxes: (4, 4, 6, 6, 6) for years 1 through 5. At the end of ve years, the melamine technology will be outdated and the plant will be sold for $1 million. Ignore depreciation and tax on salvage in this problem. To nance this cost, Roberts has been oered a $10 million loan at 10%. The loan has to be repaid in three equal installments at the end of years 3, 4 and 5, i.e., the repayment schedule is (3.33, 3.33, 3.34) million dollars at the end of years 3, 4, 5. The tax rate is 30%. The equity beta of Dr. K Melamine, a melamine particle board company is 1.2. Dr. K Melamine has a debt/equity ratio of 0.7, and its debt is practically riskfree. The market risk premium is 7% and the riskfree rate is 8%. Make sure you allow for loss carry-forwards in the cash ows. (a) Calculate the unlevered value (base case NPV) of Roberts. (b) Calculate the present value of the tax shields due to the loan. Hint : In this problem, we assume that the rm does not have income other than from this project. Thus, no corporate taxes are paid in years when the earnings after interest and before tax from this project are nonpositive.

(Optional)

6. Honda and GM are competing to sell a eet of cars to Hertz. Hertzs policies on its rental cars include use of straight-line depreciation and disposing of the cars after ve years. Hertz expects that the autos will have no salvage value. The rm expects a eet of 25 cars to generate $100,000 per year in pretax income (i.e., extra revenues minus extra expenses). Hertz is in the 34% tax bracket, and the rms overall (all-equity) required return is 10%. The addition of the new eet will not add to the risk of the rm. Treasury bills are priced to yield 6%. (a) What is the maximum price that Hertz should be willing to pay for the eet of cars, assuming that Hertz stay unlevered (and it is optimal to do so)? (b) Suppose the price of the eet (in U.S. dollars) is $325,000; both suppliers are charging this price. Hertz is able to issue $200,000 in debt to nance the project. The ve-year coupon bonds can be issued at par and will carry an 8% interest rate (i.e., only the interest on the $200,000 is paid back at the end of every year for ve years, and the principal is paid back at the end of ve years). Hertz will incur no costs to issue the debt and no costs of nancial distress. What is the APV of this project if Hertz uses debt to nance the auto purchase? 2

(c) To entice Hertz to buy the cars from Honda, the Japanese government is willing to lend Hertz $200,000 at 5% (also a ve-year coupon bond). Now what is the maximum price that Hertz is willing to pay Honda for the eet of cars?

Solutions 1. We have rA = 12%, rD = 8%, and tc = 30%. The net present value of the project for an all-equity rm would be: NPV = 1,000,000 + 600,000 700,000 + = 93,750. 1.12 (1.12)2

If $300,000 of the project is nanced with debt to be repaid in two equal installment of I , we must have: I I + I = 168,230.77. 300,000 = 1.08 (1.08)2 In the rst years installment, $300,0000.08 = $24,000 consist of interest; the rest (144,230.77) is principal repayment, reducing the debt outstanding in the second year to $155,769.23. This also implies that the interest payment in the second year is $155, 769.23 0.08 = $12,461.54. In sum, the tax shields at the end of each of the next two years will be calculated as follows: Year 1 2 Total The adjusted present value of the project is therefore APV = NPV + PV (tax shields) = 93,750 + 9,871.79 = 103,621.79. 2. The unlevered net present value of the project is NPVU = 25 + 4.5a 1012% = 25 + 1 4.5 = 0.426. 1 0.12 (1.12)10 Debt outstanding at start of year 300,000.00 155,769.23 Interest 24,000.00 12,461.54 Interest tax shield 7,200.00 3,738.46 PV (@8%) of tax shield 6,666.67 3,205.13 9,871.79

The annual tax shield is calculated based on the debt repayment schedule: End of Year 1 2 11.250 1.000 1.250 2.250 0.340 10.000 0.900 1.250 2.150 0.306

0 Debt outstanding Interest payment Principal payment Total payment on the debt Interest tax shield 12.50

9 1.250 0.200 1.250 1.450 0.068

10 0.000 0.100 1.250 1.350 0.034

The present value of these tax shields is PV (tax shields) = 0.306 0.068 0.034 0.340 + + + + = 1.398. 1.08 (1.08)2 (1.08)9 (1.08)10

Thus the adjusted present value of the project is APV = 0.426 + 1.398 = 1.824. 4

3. We know that APV = NPVU (project) + PV (nancing). Here, NPVU (project) = 1,500,000, and PV (nancing) = PV (oatation costs) + PV (debt tax shields). Now, the present value of the oatation costs is PV (oatation costs) = 60,000 + 60,000 (0.34)a 5 10% 5 12,000(0.34) 1 = 60,000 + 1 0.10 (1.10)5 = 44,533.59,

and the present value of the debt tax shields is PV (debt tax shields) = (0.34 10,000,000 10%)a 510% 1 340,000 1 = 0.10 (1.10)5 = 1,288,867.50. Therefore, APV = 1,500,000 44,533.59 + 1,288,867.50 = 2,744,333.91. 4. We are given rf = 0.10, rm = 0.18, and tc = 45%. (a) Let us rst calculate the expected return on RDs stock using the CAPM: rE = rf + (rm rf )E = 0.08 + (0.18 0.08)(1.5) = 0.23. RD is nanced with 100,000 $12.50 = $1,250,000 of equity and $750,000 of debt, i.e., E = 1,250,000, D = 750,000, V = D + E = 2,000,000, D/V = 0.375, and E/V = 0.625. This means that the present value of its tax shields is tc D = 0.45 750,000 = 337,500, and the value of its unlevered assets is A = V PV (tax shields) = 2,000,000 337,500 = 1,662,500.
1,662,500 In other words, a fraction 2 ,000,000 = 0.83125 of the rms value comes from its assets, and a fraction 1 0.83125 = 0.16875 comes from its tax shields. Since the rms tax shields have the same risk as its debt, we have

0.83125rA + 0.16875rD = 0.375rD + 0.625rE 0.83125rA + 0.16875(0.11) = 0.375(0.11) + 0.625(0.23) rA = 0.2002. Since the project has the same risk as RDs assets, the appropriate discount rate is 20.02% (when unlevered). 5

Alternatively, we could have gured out this rate by unlevering the beta of RDs equity, r D r f 0.03 after observing through CAPM that RDs debt has D = rm rf = 0.10 = 0.3: A = E + 1+
D E D E

(1 tc )D (1 tc )

1.5 + 1+

0.375 0.625 0.375 0.625

(1 0.45)0.3 = 1.2022556. (1 0.45)

Using the CAPM, we nd rA = rf + A (rm rf ) = 0.08 + (1.2022556)(0.18 0.08) = 20.02%. Yet another alternative to get this rate is by unlevering RDs weighted average cost of capital (WACC). Indeed, RDs WACC is WACCL = (1 tc )rD D E + rE = (1 0.45)(0.11)(0.375) + (0.23)(0.625) = 0.1664375. V V

Since WACCL = rA 1 tc D V , we have rA = 0.1664375 WACCL = 0.2002. = D 1 (0.45)(0.375) 1 tc V

(b) The adjusted present value (APV) of the project is given by APV = 750,000 + NPV (project) + PV (interest tax shields) PV (after-tax issuance costs). In each of the projects ve years, the after-tax cash ows will be CF = (after-tax prots) + (depreciation tax shields) 750,000 = 360,000(1 tc ) + tc 5 = 360,000(1 0.45) + 0.45(150,000) = 265,500. Therefore, using the discount rate rA calculated in part (a), we have NPV (project) = 265,500a 5 0.2002 = 265,500 1 = 793,613.59. 1 0.2002 (1.2002)5

The present value of the interest tax shields can be calculated using the following table: Debt outstanding at start of year 750,000 600,000 450,000 300,000 150,000 6 Interest tax shield 33,750 27,000 20,250 13,500 6,750

Year 1 2 3 4 5

Interest 75,000 60,000 45,000 30,000 15,000

Therefore, we have PV (interest tax shields) = Finally, the after-tax issuance costs are PV (after-tax issuance costs) = 4% 750,000 (1 0.45) = 16,500. The adjusted present value of the project is therefore APV = 750,000 + 793,613.59 + 81,621.89 16,500 = 108,735.48. 5. (a) In calculating the base case NPV, it is important to note that we are considering a similar but ctitious rm with no leverage. We rst nd the cost of equity for the unlevered rm (that has the same business risk). Using Dr. K Melamine as the appropriate benchmark rm, the asset beta (unlevered beta) is A = 1+
D E

6,750 33,750 + + = 81,621.89. 1.10 (1.10)5

1.2 E = 0.805. = 1 + (0 . 7)(1 0.30) (1 tc )

Using the CAPM, we obtain the expected return on the unlevered assets (i.e., the cost of unlevered equity): rA = rf + A (rm rf ) = 0.08 + (0.805)(0.07) = 13.6%. The cash ows given in the problem are earnings before interest and taxes. In year 1, we have an EBIT of $4 million and thus no taxes are paid. This loss is carried forward to year 2 and osets the EBIT in the second year. Thus taxes are to be considered only on incomes for years 3, 4, and 5, as shown in the following table (which is in 000s). 1 EBIT Loss carry-forwards Taxable income Taxes (TA ) After-tax cash ows (EBIT TA ) -4,000 0 -4,000 0 -4,000 2 4,000 -4,000 0 0 4,000 3 6,000 0 6,000 1,800 4,200 4 6,000 0 6,000 1,800 4,200 5 6,000 0 6,000 1,800 4,200

We can now nd the value of the unlevered rm:

salvage value after-tax cash ows

VU = 10,000 + = 2,286.

4,000 1,000 4,000 4,200 4,200 4,200 + + + + 5 2 3 4 (1.136) 1.136 (1.136) (1.136) (1.136) (1.136)5

In the next part, we need to calculate the present value of interest tax shields resulting from $1 million in interest in years 1, 2, and 3. (There is additional interest in years 4 and 5 that I handle later.) 7

The twist in this problem is that having interest deductions in years 1 and 2 does you no good because you are not paying taxes anyway. (Why? Because you have a loss in year 1, and the loss is carried forward to completely shield the income you make in year 2, so you pay no taxes in year 1 or year 2 even without interest deductions.) The interest that you pay in years 1 and 2 makes your carry forward a loss larger than that above; that is, the interest is stored up (i.e., carried forward) and taken in year 3, along with the additional $1 million of interest you have in year 3. (The rm is quite protable in year 3, so it takes all $3 million of interest deduction at that time.) So, having debt adds $3tc million to your cash ow in year 3, but nothing (relative to having no debt) in year 1 or year 2. (b) First, we have to gure out the debt repayment schedule: 0 Debt outstanding Interest payment (@10%) 10,000 1 10,000 1,000 2 10,000 1,000 3 6,667 1,000 4 3,333 667 5 0 333

We can now calculate the tax shields that this debt generates: 1 EBIT Interest payment EBT Loss carry-forwards Taxable income Taxes (TB ) TB TA -4,000 1,000 -5,000 0 -5,000 0 0 2 4,000 1,000 3,000 -3,000 0 0 0 3 6,000 1,000 5,000 -2,000 3,000 900 900 4 6,000 667 5,333 0 5,333 1,600 200 5 6,000 333 5,667 0 5,667 1,700 100

There are two ways of computing the amount of tax shield due to the loan. One way is by comparing the amount of taxes Roberts pays with the loan vs without the loan (see the two tables). For example, in year 3, Roberts pays $0.9 million in taxes with the loan vs. paying $1.8 million in taxes without using the loan. Thus, it is a saving of $0.9 million due to the loan tax shield. An alternative way of nding out the tax shield amount is to use the tax rate (30%) to multiply the interest payment in years 4 and 5. For year 3, use 30% to multiply 1 + 1 + 1 = 3 million because all the interest payment in years 1, 2, and 3 are used to oset taxable income in year 3. There is no tax shield available in years 1 and 2 because there is no positive taxable income. The present value of these tax shields is PV (tax shields) = 200 100 900 + + = 875. 3 4 (1.10) (1.10) (1.10)5

Thus the adjusted present value is APV = 2,286 + 875 = 1,411. 6. (a) If Hertz is an all-equity rm, we only need to discount the cash ows of the project at rA = 10% to nd the net present value of the project. The maximum price P that Hertz 8

should be willing to pay for the eet of cars is the price that will make that net present value equal to zero: 0 = NPV = P + 100,000(1 0.34) a 5 10% + income P (0.34) a 5 10% . 5 depreciation tax shield

Since a 510% = 3.7907868, we can solve for P to get a maximum price of P = 337,082.99. (b) We know that the adjusted net present value (APV) of the project can be calculated in two parts. First, let us calculate the net present value of the project, assuming that it is undertaken by an all-equity rm: NPVU = 325,000 + 100,000(1 0.34) a 5 10% + 325,000 (0.34) a 510% 5 325,000 (0.34)(3.7907868) = 325,000 + 100,000(1 0.34)(3.7907868) + 5 = 8,968.31.

The second part has to do with the tax shields resulting from the interest payments on the debt used to nance the project. The present value of these tax shields is given by PV (interest tax shields) = tc rD D a 58% = (0.34)(8%)(200,000)(3.9927100) = 21,720.34. So, the adjusted present value of the project is APV = NPVU + PV (interest tax shields) = 8,968.31 + 21,720.34 = 30,688.66. (c) If the Japanese government oers Hertz this cheap loan, the APV also needs to account for the fact that Hertz is eectively making a prot out of the loan. Indeed, we assumed in class that all transactions in the capital markets are zero NPV transactions. However, since the Japanese government is now eectively willing to give Hertz the loan at a below-market rate, this means that Hertz prots from the loan itself, not just the tax shields. So, the APV of the project is now given by depreciation tax shield income P P + 100,000(1 0.34) a 510% + (0.34) a 5 10% 5 + PV (interest tax shields) + NPV (loan),

APV =

(1)

where PV (interest tax shields) = tc rD D a 58% = (0.34)(5%)(200,000)(3.9927100) = 13,575.21.

and NPV (loan) = D rD D a 58% D (1.08)5 200,000 (1.08)5

= 200,000 (5%)(200,000)(3.9927100) = 23,956.26.

We can solve for P in (1) to obtain the maximum price that Hertz would be willing to pay for the eet of cars, that is P = 387,649.05.

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