11 Jul DETERMINE THE VALUE OF THE TAX SHIELD OF INTEREST.
Assignment 5 – Valuing a leveraged firm
Do this assignment individually.
A firm is planning to take a project that if funded entirely with equity has net after tax cash flows as indicated in the table below.
Year Cash flow
0 -15000000
1 2000000
2 2000000
3 2000000
4 2000000
5 2000000
6 2000000
7 2000000
8 2000000
9 2000000
10 2000000
11 3000000
12 3000000
13 3000000
14 3000000
15 3000000
16 3000000
17 3000000
18 3000000
19 3000000
20 12000000
The firm estimates that the asset beta for comparable projects is 1.28. The risk free interest rate is 3.0% and the firm expects the market return over the next 20 years to average 12.0%. The project will operate as a corporation with a combined federal and state income tax rate of 26%.
The firm plans to fund 30% of the project with debt that pays 3.0% interest annually for 20 years at which time the entire principal is due.
For all of the following, use annual cash flows and annual interest payments.
1a. Using the capital asset pricing model, determine the required return of the project if funded entirely with equity.
Calculate the net present value of the project if funded entirely with equity.
2a. Find the leveraged equity beta.
Calculate the required return on leveraged equity. (You may use the capital asset pricing model or calculate the return directly using the debt equity ratio, the return on unleveraged equity and the interest rate.)
Determine the weighted average cost of capital.
Using the WACC method, what is the net present value of the leveraged project?
3a. Calculate the amount of the each annual interest payment on the loan.
Calculate the present value of the interest payments.
Determine the value of the tax shield of interest.
Using the APV method, what is the net present value of the leveraged project?
4a. Determine the initial investment by equity in the project and the annual cash flows to equity for the project in years 1-10, years 11-19, and year 20.
Using the FTE method, what is the net present value of the leveraged project?
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