MNA is a retail store that operates through its stores across the USA. The following table (MNA Data as of end of 2016) shows data as of end 2016. BOD is a group considering LBO (leveraged buyout option) of MNA at the beginning of 2017. BOD is considering 25% equity and 75% debt. Group made the projections for 10 years (2017 through 2026) as shown below.
MNA Data as of end 2016
Debt on balance sheet $4,658 millions
Shareholders' equity at book value $3,524 millions
Market value of equity $6,300 millions
Market equity beta 0.88
Income tax rate 35%
BOD Assumptions
Debt 75%
Equity 25%
___________________________________________
Risk free rate 4.2%
Market risk premium 5%
Interest Rate 10%
Free cash flows to equity and debt holders (millions)
Year 2017 $778 Year 2018 $821 Year 2019 $864 Year 2020 $790 Year 2021 $754 Year 2022 $864 Year 2023 $859 Year 2024 $887 Year 2025 $945 Year 2026 $1,014
Questions:
a. Compute the unlevered market equity beta (asset beta) of MNA. Assume that the market value of debt is same as the book value.
b. Compute the cost of equity for BOD group with new capital structure. Risk free rate and market risk premium are provided in table BOD assumptions above.
c. Using the cost of equity calculated in question b, compute the weighted average cost of capital for BOD. Interest rate is provided in the table BOD assumptions.
d. Compute the present value of free cash flows to all debt and equity capital stakeholders at the weighted average cost of capital. Ignore the midyear adjustment. Assume that the free cash flows grow at 3% after 2026 for computing the continuing value.
e. Assume that BOD acquired MNA for the value calculated in d. Will BOD have the cash flows sufficient to pay the interest? Explain.
MNA is a retail store that operates through its stores across the USA. The following table (MNA Data as of end of 2016) shows data as of end 2016. BOD is a group considering LBO (leveraged buyout option) of MNA at the beginning of 2017. BOD is considering 25% equity and 75% debt. Group made the projections for 10 years (2017 through 2026) as shown below.
MNA Data as of end 2016
Debt on balance sheet $4,658 millions
Shareholders' equity at book value $3,524 millions
Market value of equity $6,300 millions
Market equity beta 0.88
Income tax rate 35%
BOD Assumptions
Debt 75%
Equity 25%
___________________________________________
Risk free rate 4.2%
Market risk premium 5%
Interest Rate 10%
Free cash flows to equity and debt holders (millions)
| Year 2017 | $778 |
| Year 2018 | $821 |
| Year 2019 | $864 |
| Year 2020 | $790 |
| Year 2021 | $754 |
| Year 2022 | $864 |
| Year 2023 | $859 |
| Year 2024 | $887 |
| Year 2025 | $945 |
| Year 2026 | $1,014 |
Questions:
a. Compute the unlevered market equity beta (asset beta) of MNA. Assume that the market value of debt is same as the book value.
b. Compute the cost of equity for BOD group with new capital structure. Risk free rate and market risk premium are provided in table BOD assumptions above.
c. Using the cost of equity calculated in question b, compute the weighted average cost of capital for BOD. Interest rate is provided in the table BOD assumptions.
d. Compute the present value of free cash flows to all debt and equity capital stakeholders at the weighted average cost of capital. Ignore the midyear adjustment. Assume that the free cash flows grow at 3% after 2026 for computing the continuing value.
e. Assume that BOD acquired MNA for the value calculated in d. Will BOD have the cash flows sufficient to pay the interest? Explain.
Related questions
ch 14
5.
Scanlin, Inc., is considering a project that will result in initial aftertax cash savings of $1.84 million at the end of the first year, and these savings will grow at a rate of 1 percent per year indefinitely. The firm has a target debtâequity ratio of 0.75, a cost of equity of 12.4 percent, and an aftertax cost of debt of 5.2 percent. The cost-saving proposal is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and applies an adjustment factor of 3 percent to the cost of capital for such risky projects.
| What is the maximum initial cost the company would be willing to pay for the project? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount.) |
| Maximum cost | $ |
7.
Suppose you have been hired as a financial consultant to Defense Electronics, Inc. (DEI), a large, publicly traded firm that is the market share leader in radar detection systems (RDSs). The company is looking at setting up a manufacturing plant overseas to produce a new line of RDSs. This will be a five-year project. The company bought some land three years ago for $4.2 million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. The land was appraised last week for $5.0 million. In five years, the aftertax value of the land will be $5.4 million, but the company expects to keep the land for a future project. The company wants to build its new manufacturing plant on this land; the plant and equipment will cost $31.76 million to build. The following market data on DEIâs securities are current:
| Debt: | 227,000 7.4 percent coupon bonds outstanding, 25 years to maturity, selling for 109 percent of par; the bonds have a $1,000 par value each and make semiannual payments. |
| Common stock: | 8,500,000 shares outstanding, selling for $70.70 per share; the beta is 1.2. |
| Preferred stock: | 447,000 shares of 6 percent preferred stock outstanding, selling for $80.70 per share. |
| Market: | 8 percent expected market risk premium; 6 percent risk-free rate. |
| DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 9 percent on new common stock issues, 7 percent on new preferred stock issues, and 5 percent on new debt issues. Wharton has included all direct and indirect issuance costs (along with its profit) in setting these spreads. Wharton has recommended to DEI that it raise the funds needed to build the plant by issuing new shares of common stock. DEIâs tax rate is 38 percent. The project requires $1,225,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally and that the NWC does not require floatation costs.. |
| a. | Calculate the projectâs initial time 0 cash flow, taking into account all side effects. (Negative amount should be indicated by a minus sign. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount.) |
| Cash flow | $ |
| b. | The new RDS project is somewhat riskier than a typical project for DEI, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of 3 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEIâs project. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) |
| Discount rate | % |
| c. | The manufacturing plant has an eight-year tax life, and DEI uses straight-line depreciation. At the end of the project (that is, the end of year 5), the plant and equipment can be scrapped for $4.2 million. What is the aftertax salvage value of this plant and equipment? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations.) |
| Aftertax salvage value | $ |
| d. | The company will incur $6,500,000 in annual fixed costs. The plan is to manufacture 15,500 RDSs per year and sell them at $10,650 per machine; the variable production costs are $9,250 per RDS. What is the annual operating cash flow (OCF) from this project? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.) |
| Operating cash flow | $ |
| e. | DEIâs comptroller is primarily interested in the impact of DEIâs investments on the bottom line of reported accounting statements. What will you tell her is the accounting break-even quantity of RDSs sold for this project? (Do not round intermediate calculations and round your final answer to nearest whole number.) |
| Break-even quantity | units |
| f. | Finally, DEIâs president wants you to throw all your calculations, assumptions, and everything else into the report for the chief financial officer; all he wants to know is what the RDS projectâs internal rate of return (IRR) and net present value (NPV) are. (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16)) |
| IRR | % |
| NPV | $ |
