A firm has financed its operations by borrowing from banks and issuing longterm bonds and equity....
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A firm has financed its operations by borrowing from banks and issuing longterm bonds and equity. The shortterm bank debt has a book value of $1 million and pays 3% interest. The 30year bonds (5% coupon rate, YTM=5%, no default risk) have a combined face value of $6 million. The firm has issued 100,000 shares of stock with a par value of $2 each, although the current market price is $50 each. The firm beta is 0.8. Now the firm is considering a new investment project. This is a 12year project that would require an initial investment of $750,000 for fixed capital, i.e. new equipment, buildings, etc. This investment would be depreciated using a straightline depreciation schedule over 20 years to a value of 0. The project beta is 1.3. For the next 12 years the investment project is expected to save $45,000 in costs every year and generate an additional annual revenue of $20,000. The project also requires an investment in working capital of $50,000 today, and additional $10,000 every year for years 1 11 and then half of the accumulated working capital is freed up in year 12. At the end of the project the fixed capital is sold for $250,000 to a Japanese investor. The corporate tax rate is 35%, the stock market return is 12%, the riskfree return is 4% (compared to 2% in Japan) and the spot exchange rate is 104 yen per dollar. a) For the purpose of calculating the firm's WACC, what fraction of the firm's financing comes from shareholders? b) What is the total cash flow in year 0, years 111 and year 12? c) What is the NPV of the project? Should you go ahead with the project? d) Suppose the Japanese investor instead pays you 78 million yen for the machine 12 years from now. The spot exchange rate is currently 104 yen per dollar. Recalculate the NPV. Should you go ahead with the project? e) Now suppose an extremely severe financial crisis is expected to hit the US and the dollar is likely to plummet. While the spot rate is still unchanged, a 12year forward contract locks in an exchange rate of 16 yen per dollar. Should you now go ahead with the project if the Japanese investor buys the machine for 78 million yen? f) Under the circumstances described in part e), demonstrate how you can make a large riskless profit (arbitrage) on a $1 investment.
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Answer rating: 100% (QA)
SOLUTION a In order to calculate the firm s weighted average cost of capital WACC we need to determine the proportion of financing that comes from shareholders Total book value of short term bank debt View the full answer
Related Book For
Foundations of Financial Management
ISBN: 9781259024979
10th Canadian edition
Authors: Stanley Block, Geoffrey Hirt, Bartley Danielsen, Doug Short, Michael Perretta
Posted Date:
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