Chapter 17 Questions V1
Valuation and Capital Budgeting for the Levered Firm
Adjusted Present Value
17.1 Honda and GM are competing to sell a fleet of 25 cars to Hertz. Hertz fully depreciates all of its rental cars over five years using the straight-line method. The firm expects the fleet of 25 cars to generate $100,000 per year in earnings before taxes and depreciation for five years. Hertz is an all-equity firm in the 34-percent tax bracket. The required return on the firm’s unlevered equity is 10 percent, and the new fleet will not add to the risk of the firm.
a. What is the maximum price that Hertz should be willing to pay for the new fleet of cars if it remains an all-equity firm?
b. Suppose Hertz purchases the fleet from GM for $325,000, and Hertz is able to issue $200,000 of five year, 8% debt in order to finance the project. All principal will be repaid in one balloon payment at the end of the fifth year. What is the Adjusted Present Value (APV) of the project?
17.2 Gemini, Inc., an all-equity firm, is considering a $2.1 million investment that will be depreciated according to the straight-line method over its three-year life. The project is expected to generate earnings before taxes and depreciation of $900,000 per year for three years. The investment will not change the risk level of the firm. Gemini can obtain a three-year, 12.5% loan to finance the project from a local bank. All principal will be repaid in one balloon payment at the end of the third year. The bank will charge the firm $21,000 in flotation fees, which will be amortized over the three-year life of the loan. If Gemini financed the project entirely with equity, the firm’s cost of capital would be 18%. The corporate tax rate is 30%. Using the Adjusted Present Value (APV) method, determine whether or not Gemini should undertake the project.
17.3 MVP, Inc., has produced rodeo supplies for over 20 years. The company currently has a debt-to-equity ratio of 25% and is in the 40% tax bracket. The
Adjusted Present Value
17.1 Honda and GM are competing to sell a fleet of 25 cars to Hertz. Hertz fully depreciates all of its rental cars over five years using the straight-line method. The firm expects the fleet of 25 cars to generate $100,000 per year in earnings before taxes and depreciation for five years. Hertz is an all-equity firm in the 34-percent tax bracket. The required return on the firm’s unlevered equity is 10 percent, and the new fleet will not add to the risk of the firm.
a. What is the maximum price that Hertz should be willing to pay for the new fleet of cars if it remains an all-equity firm?
b. Suppose Hertz purchases the fleet from GM for $325,000, and Hertz is able to issue $200,000 of five year, 8% debt in order to finance the project. All principal will be repaid in one balloon payment at the end of the fifth year. What is the Adjusted Present Value (APV) of the project?
17.2 Gemini, Inc., an all-equity firm, is considering a $2.1 million investment that will be depreciated according to the straight-line method over its three-year life. The project is expected to generate earnings before taxes and depreciation of $900,000 per year for three years. The investment will not change the risk level of the firm. Gemini can obtain a three-year, 12.5% loan to finance the project from a local bank. All principal will be repaid in one balloon payment at the end of the third year. The bank will charge the firm $21,000 in flotation fees, which will be amortized over the three-year life of the loan. If Gemini financed the project entirely with equity, the firm’s cost of capital would be 18%. The corporate tax rate is 30%. Using the Adjusted Present Value (APV) method, determine whether or not Gemini should undertake the project.
17.3 MVP, Inc., has produced rodeo supplies for over 20 years. The company currently has a debt-to-equity ratio of 25% and is in the 40% tax bracket. The