Suppose you are evaluating the following startup idea. you believe you will be able to run the

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Question:

"Suppose you are evaluating the following startup idea. you believe you will be able to run the firm for three years, starting today (January1,2021) and ending on December 31, 2023 you expect to generate revenue at the end of each year of $200 million, and incur labor costs of $100 million at the end of each year. You already own the assets you will use for production, so you do not need to make any new capital expenditures. however, you will be able to claim depreciation expenses of $20 million per year for the next three years (the production assets will have no salvage value). The tax rate is 25%. All cash flows realized at the end of each year.

Based on your analysis of similar business, the unlevered cost of capital for your firm will be 9%. you don’t know how much the cost of debt will be; it will depend on the credit rating given by the bank that you get a loan from, which in turn based on expected interest coverage ratios each year.

Credit rating	AAA	AA	A	BBB	BB	B
Cost of debt	4%	5%	7%	10%	13%	17%
Interest cov (EBITDA/interest payment)	225	140	40	20	10	3

Suppose you wish to finance the firm by getting a bank loan in the form of amortized debt today (i.e. a 3-year loan with annual interest and principal payments; the sum of interest and principal is constant each year). You expect to pay off the loan in full by the end of the project.

[20 marks] suppose the loan amount is $30 million.

Please show the balance sheet of the firm in market values each year. That is, please show the market value of the total assets of the firm, the market value of its equity and its debt, on January 1 of each year (i.e 2021,2022, and 2023).

B) [ 15 marks] suppose you wish to maximize the loan amount today, such that you are still able to maintain at least a BBB credit rating throughout the entire life of the project. Assume that when you get the loan today, the bank commits to maintaining the same interest for the entire life of the loan. ( i.e you cannot restructure the loan and change the interest rate over time, even if the interest coverage ratio increases over time)

C) [15 marks] suppose that after taking out a loan that gives you a BBB rating as in part b) above, a private equity firm sweeps in and offers to buy your firm on January 1, 2022 (they wish to be the sole owner of the firm). They plan to take out a loan of their own to buy out your firm and they are planning to maximize the amount that they borrow such that they still have a BB rating.

How much is the PE firm willing to pay for the firm?