Your firm is considering a new three-year project. You know that the
unlevered cost of equity for firms with a similar risk as your target is 8%. At the end of the
project, all available funds are distributed to equity and debt holders. Use the following
financial statements to answer the questions on the next page:
Year
0
1
2
3
Income statement
Sales
$175,000
$175,000
$175,000
COGS
$26,250
$26,250
$26,250
Depreciation
$100,000
$100,000
$100,000
EBIT
$48,750
$48,750
$48,750
Interest payment on debt
$9,000
$9,000
$9,000
Profit Before tax
$39,750
$39,750
$39,750
Taxes
$21,863
$21,863
$21,863
Profit after tax
$17,888
$17,888
$17,888
Dividends
$17,888
$17,888
$17,888
Retained earnings
$0
$0
$0
Balance Sheet
Cash and Mark. Sec.
$0
$100,000
$200,000
$300,000
Current Assets
$0
$0
$0
$0
Fixed Assets
At cost
$300,000
$300,000
$300,000
$300,000
Acc. Depreciation
$0
$100,000
$200,000
$300,000
Net Fixed Assets
$300,000
$200,000
$100,000
$0
Total Assets
$300,000
$300,000
$300,000
$300,000
Current liabilities
$0
$0
$0
$0
Debt
$150,000
$150,000
$150,000
$150,000
Stock
$150,000
$150,000
$150,000
$150,000
Acc. Ret. Earn.
$0
$0
$0
$0
Total liab.and equity
$300,000
$300,000
$300,000
$300,000
- a) How large an equity investment does the project require upfront?
- b) How much equity is recovered at the end of the project?
- c) Show the cash to and from equity holders for the entire project. Don’t forget
about dividends, initial, and terminal equity flows. Actual cash, not free cash flow!
Year
0
1
2
3
Total cash flows to equity
- d) Based on the cash flows in part c, what is the IRR for the equity holders?
- e) What is the present value of the tax shield for this three-year project?
Remember, this is not a perpetuity, it’s a three-year project.
- f) Is this a good project for shareholders?
Your firm is considering a new three-year project. You know that the
unlevered cost of equity for firms with a similar risk as your target is 8%. At the end of the
project, all available funds are distributed to equity and debt holders. Use the following
financial statements to answer the questions on the next page:
Year
0
1
2
3
Income statement
Sales
$175,000
$175,000
$175,000
COGS
$26,250
$26,250
$26,250
Depreciation
$100,000
$100,000
$100,000
EBIT
$48,750
$48,750
$48,750
Interest payment on debt
$9,000
$9,000
$9,000
Profit Before tax
$39,750
$39,750
$39,750
Taxes
$21,863
$21,863
$21,863
Profit after tax
$17,888
$17,888
$17,888
Dividends
$17,888
$17,888
$17,888
Retained earnings
$0
$0
$0
Balance Sheet
Cash and Mark. Sec.
$0
$100,000
$200,000
$300,000
Current Assets
$0
$0
$0
$0
Fixed Assets
At cost
$300,000
$300,000
$300,000
$300,000
Acc. Depreciation
$0
$100,000
$200,000
$300,000
Net Fixed Assets
$300,000
$200,000
$100,000
$0
Total Assets
$300,000
$300,000
$300,000
$300,000
Current liabilities
$0
$0
$0
$0
Debt
$150,000
$150,000
$150,000
$150,000
Stock
$150,000
$150,000
$150,000
$150,000
Acc. Ret. Earn.
$0
$0
$0
$0
Total liab.and equity
$300,000
$300,000
$300,000
$300,000
- a) How large an equity investment does the project require upfront?
- b) How much equity is recovered at the end of the project?
- c) Show the cash to and from equity holders for the entire project. Don’t forget
about dividends, initial, and terminal equity flows. Actual cash, not free cash flow!
Year
0
1
2
3
Total cash flows to equity
- d) Based on the cash flows in part c, what is the IRR for the equity holders?
- e) What is the present value of the tax shield for this three-year project?
Remember, this is not a perpetuity, it’s a three-year project.
- f) Is this a good project for shareholders?
Related questions
| Use the below information to answer the following question. |
| Income Statement | |
| For the Year | |
| Sales | $42,700 |
| Cost of goods sold | 29,250 |
| Depreciation | 3,750 |
| Earnings before interest and taxes | $ 9,700 |
| Interest paid | 1,360 |
| Taxable income | $ 8,340 |
| Taxes | 2,840 |
| Net income | $ 5,500 |
| Dividends $1,925 | |
| Balance Sheet | |
| End-of-Year | |
| Cash | $1,320 |
| Accounts receivable | 3,780 |
| Inventory | 10,200 |
| Total current assets | $15,300 |
| Net fixed assets | 33,600 |
| Total assets | $48,900 |
| Accounts payable | $ 3,650 |
| Long-term debt | 18,100 |
| Common stock ($1 par value) | 15,000 |
| Retained earnings | 12,150 |
| Total Liab. & Equity | $48,900 |
| The profit margin, the debt-equity ratio, and the dividend payout ratio for this firm are constant. Sales are expected to increase by $5,000 next year. What is the projected addition to retained earnings for next year? |
(ALL WORK MUST BE DONE ON EXCEL)
Build a financial model on the following template. Assume that the WACC is 20%. Also assume the debt and equity remain the same. The FCF long-term growth rate is the same as the sales growth rate. ( Copy the table into Excel.)
| Sales growth | 10% | |||||
| Current assets/sales | 15% | |||||
| Current liabilities/Sales | 8% | |||||
| Net fixed assets/sales | 77% | |||||
| cost of goods sold/sales | 50% | |||||
| depreciation rate | 10% | |||||
| interest rate on debt | 10% | |||||
| interest paid on cash and marketable securities | 8% | |||||
| tax rate | 40% | |||||
| dividend payout ratio | 40% | |||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| income statement | ||||||
| sales | 1000 | |||||
| cost of goods sold | 500 | |||||
| interest payment on debt | 32 | |||||
| interest earned on cash and marketable securities | 6 | |||||
| depreciation | 100 | |||||
| profits before tax | 374 | |||||
| taxes | 150 | |||||
| profits after tax | 225 | |||||
| dividends | 90 | |||||
| retained earnings | 135 | |||||
| Balance sheet | ||||||
| cash and marketable securities | 80 | |||||
| current assets | 150 | |||||
| fixed assets | ||||||
| At cost | 1070 | |||||
| depreciation | 300 | |||||
| Net fixed assets | 770 | |||||
| total assets | 1000 | |||||
| current liabilities | 80 | |||||
| debt | 320 | |||||
| stock | 450 | |||||
| accumulated retained earnings | 150 | |||||
| total liabilities + Equity | 1000 |
a. Value the companyâs equity. (SHOW YOUR WORK ON EXCEL)
b. The model in Part A includes cost of goods sold but not selling, general, and administrative (SG & A) expenses. Suppose that the firm has $200 of these expenses each year, irrespective of the level of sales. Change the model to accommodate this new assumption. Show the resulting income statements, balance sheets, the free cash flows (FCF), and the valuation. (SHOW YOUR WORK ON EXCEL)
c. Build a data table in which you show the sensitivity of the equity value to the level of SG & A. Let SG & A vary from $0 per year to $600 per year. (SHOW YOUR WORK ON EXCEL)
d. Back to Part A. Suppose that the fixed assets at cost follow the following step function:
Incorporate this function into the model and solve for the market value of equity. (SHOW YOUR WORK ON EXCEL)
e. Back to Part A again. Make two changes in the model: 1). Let debt be the plug and keep cash constant at its year-0 level. 2). Suppose that the firm has 1,000 shares and that it decides to pay, in year 1, a dividend per share of $0.15. In addition, suppose that it wants this dividend per share to growth in subsequent years by 12% per year. Incorporate these changes into the pro forma model and solve this model to get the market value of equity per share. (SHOW YOUR WORK ON EXCEL)
