Class 15 - Practice Problems
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University of British Columbia**We aren't endorsed by this school
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COMM 196
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Communications
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Dec 16, 2024
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COMM 370 The University of British Columbia | Sauder School of Business | COMM 370 | Do not post online 1 A. Study Questions 1.Explain what a project’s “debt capacity” is and how it is related to valuation using WACC.2. Explain the flow-to-equity (FTE) valuation method, including what cash flow and discount rate it uses.3. When are WACC and FTE practical valuation methods to use?4.What is debt with a “fixed schedule” and in what situations do firms have this debt policy?5.Suppose a project will be financed in part with debt and that this debt has a fixed schedule. What is the right discount rate to apply to the interest tax shields generated by such debt financing? 6. Explain how the adjusted present value (APV) method works and how it compares to valuation with WACC (e.g., discount rates, how interest tax shields are captured; when it is easier to use). 7.Explain why the adjusted present value method is useful to value a target for a leveraged buyout. B. Short Calculation Problems 1.Cirrus Corp is considering a factory to produce winter tires which requires an initial investment of $100M and will generate a free cash flow of $50M in each of the next three years and be abandoned afterwards with no salvage value. Cirrus maintains a target D/E = 2/3. Its corporate tax rate is 40%, its cost of debt is 5%, and its cost of equity is 10%. a) Calculate the project’s value (present value of future free cash flow) and NPV. b)Calculate the project’s annual debt capacity and net debt issuance (use a table). c) Calculate the amount of equity the firm will issue in year 0.d)What are the amounts of debt and equity issuance used to cover the $100M cost of the project? 2. Using the estimated debt capacity and borrowing in question 1 above, now compute the NPV of the project Cirrus Corp is considering using the FTE method. 3. A firm maintains a debt-to-value ratio of 50% which it imposes on all its new projects. It is considering a project that generates $15M in annual free cash flow forever, has a cost of capital of 10%, and costs $80M up front to undertake. Note: here you will see how assuming a perpetual FCF changes things! a) What is the project’s value (present value of free cash flow) and NPV?
COMM 370 The University of British Columbia | Sauder School of Business | COMM 370 | Do not post online 2 b)What is the project’s annual debt capacity and net debt issuance?c) Calculate the amount of equity the firm will issue in year 0.d)What are the amounts of debt and equity issuance used to cover the $80M cost of the project? 4.An entrepreneur will start a new firm which costs $15M up front and generates $6M in free cash flow in each of the following 5 years. The firm will face a 40% tax rate and its unlevered cost of capital is 10%. To fund the required investment, the firm will borrow $10M for 5 years under a loan contract which specifies annual interest payments at a 5% rate and repayment of the principal at the end of year 5. Note this debt has a fixed schedule. The remaining $5M will be raised with equity issuance. a)What is the NPV of the project with all-equity financing? b)What is the value of created by the project’s $10M debt financing? c)What is the project’s NPV, including the value of the financing, using the APV method? d)Assume now a different fixed schedule for the debt: the firm will borrow $10M and repay the loan in annual installments of $2M until it is fully repaid in year 5, while paying annual interest on the beginning-of-year debt balance at a 5% rate. What is the value of created by the project’s $10M debt financing? Use a table! How does it compare to the amount obtained in b) and why?5. A firm’s main bank has established a covenant stating that the firm’s total debt cannot exceed 5 times its EBITDA. The firm’s EBITDA is $2M per year and its current total debt outstanding is $4M. a)Given its strict covenant, what is the firm’s unused borrowing capacity? b)Should the firm increase its borrowing?