Problem 4: DETERMINING THE APV FOR AN INVESTMENT PROJECT

Consider a firm which is evaluating a project to produce solar water heaters. The project requires a $10 million investment and generates after-tax free cash flows of $1.75 million per year for 10 years. The opportunity cost of capital which reflects the project's business risk equals 12%. With this information answer the following two questions.

(i)Suppose the project is financed with $5 million debt and $5 million equity. The debt is provided as a term loan, which will be repaid in equal installments over the next 10 years. The interest rate on the debt equals 8% and the marginal corporate tax rate is 35%. Should the firm undertake the investment project? Motivate your answer and show all your calculations.

(ii)Suppose you learn that the firm incurs issue costs (in the form of underwriting fees) of

$400,000 to raise the $5 million in equity for the project. How would this information affect your project recommendation? Explain your answer.

Problem 5: THE COST OF CAPITAL FOR THE HOME DEPOT FOR THE APV, WACC AND FTE- APPROACH

Revisit the cost of capital calculation for the Home Depot example on p. 63 of the handout Estimating the Discount Rate in the DCF-Framework. Based on this information, answer the following two questions (note: you may find a small difference due to rounding).

(i)Verify that the WACC calculated for the Home Depot equals 9.3% if we use the bottom- up approach to estimate the firm's equity beta and assuming that the firm maintains a constant debt ratio in market value terms.

Determine the discount rate you would use for an APV-valuation of the firm and also the discount rate you would use for a valuation based on the Flow to Equity approach