Reto S.A.

* She is considering the cash flow paid to all the equity or debt holders. So she cannot use the equity cost of capital.

Free cash flows of the project for next five years can be calculated by adding depreciation values and subtracting changes in working capital from net income. In 2010, there will be a cash outflow of $2.2 million as capital expenditure. In 2011, there will be an additional one time cash outflow of $300,000 as an advertising expense. Using net free cash flow values for next five years and discount rate for discounting, NPV for the project comes out to be $2907, 100. The rate of return at which net present value becomes zero i.e.

General speaking, WACC is the rate that a company’s shareholders expect to be paid on average to finance its assets, and it is the overall required return on the firm as a whole. Therefore, company directors often use WACC to determine whether a financial decision is feasible or not. In this case, I will choose 9.38% as discount rate. The reason why I choose 9.38% as discount rate is because the estimated Debt/Equity is 26% under the assumptions by CFO Sheila Dowling, which is most close to 25% of Debt/Equity from the projected WACC schedule. There might be some flaws existing by using WACC as discount rate. As we know, the cost of debt would be raised significantly as the leverage increased. The investment will definitely increase the firm’s current debt. So, the cost of debt would not keep at 7.75%.

Tato Laviera, a great Puerto Rican poet, writes one of his most famous and prideful poems called "AmeRican" majorly composed of metaphors, where he dreams of a time when his people, the Puerto Ricans, can create, or how as he states in his poem "give birth" to a perfect race in which we live in peace and happiness; where all cultures are welcome because we ourselves are forged by various races and cultures, and we do not judge others by mere race. Hence, comes the name of “AmeRican”, because we can make the American society a better place. The main subjects that I will focus on are the meanings embedded in the poem discussing only the most important parts, the relationship of the American and Puerto Rican culture and the tension that lies between them. I will also focus on one of the main ideas of the author: a utopian society conveyed by Puerto Rican culture.

To relever the βe, we use the formula, βe = βu +(D/E)*(βu-βd). And the “Target D/E” was found by taking “Target D/V” divided by “1-Target D/V”. So we get the new βe, 1.3576. Then to get cost of equity, we use the CAPM formula, Re=Rf+β(EMRP), 11.7679%. Since we have get the cost of equity and cost of debt, we can determined the WACC, which is equal to Equity/Value*Cost of Equity+Debt/Value*Cost of Debt*(1-tax rate). In the end ,we arrived at 8.48%.

What is the cost of equity capital appropriate for evaluating the free cash flow associated with this investment?

Assumptions need to be made for the Cost of Equity. We used the corporate rate of 11.766%

The 8 percent pre-tax estimate is the nominal cost of debt. Because the firm's debt has semiannual coupons, its effective annual cost rate is 8.16 percent

I used WACC as the discount factor, we expect the rate of return to be higher than it, the same at least. The WACC reflects the average risk and overall capital structure of the entire firm [2]. It’s the required return and it presents how much the company pays for the capital it finances. In this case, the cost of equity is 10.33%, the cost of debt is 6.50%. I calculated WACC using those numbers and got a result of 8.49%.

iii. Prepare a basic discounted cash flow analysis; i.e. compute incremental cash flows and a terminal value, and discount them at a weighted average cost of capital. Can you do a multiples-type analysis here as well?

a. What risk-free rate and risk premium did you use to calculate the cost of equity?

* Determine the investment’s value without leverage, VU, by discounting its free cash flows at the

Government interest rates from Table B, 8.72%. The 10 year rate was chosen to be consistent with time lengths. Then the value for equity, debt and the firm need to be calculated, this is a simple step. The market price of the shares is multiplied by the number of outstanding shares to find the value of equity and the book value of long term debt is used for the value of debt and the value of both equity and debt are added together to come up with the value of the firm. The weight of the equity and debt can now be calculated by dividing the value of equity or debt by the value of the company. Lastly, the tax rate was calculated by using the balance sheet, given in exhibit 1, to determine income taxes paid and dividing it by earnings before interest and taxes for each of the last ten years then by taking the average of the ten years tax rates.

Answer: When determining the incremental cash flows related to the project, we should not include interest expense, even if the project will be partly financed by debt. We will take the interest cost into consideration when we perform the net present value analysis on these cash flows. At that point, the required rate of return we will use will be a rate that will take into consideration the cost of both debt and equity financing, and therefore, the effect of interest costs (and the effect of the cost of equity) will be considered at that time. Usually, the WACC will be used as the required rate of return, as long as the project is an average-risk project for the company.

For future cash flows, evaluation is done with WACC rate which consists from cost of equity and cost of debt in a weighted average. In this case, using cost of equity is not appropriate since we doesn’t know cost of debt and weights of equity and debt, it doesn’t reflect the actual rate for WACC.