You are hired as a CFO of the company ABC. ABC has just been through an IPO process. The CEO is about to undertake a new investment project and know that one source of shareholder value is the unlevered cash flow. a) Explain the CEO another source of shareholder value when undertaking a new investment project (Don't worry if you can't answer it now, we will cover on this more in lecture 10) Answer: See exhibit 13.2 at page 435. Back to the project ABC consider undertaking. From the market analysis team you get the following infor- mation: Value of the initial levered equity is 800 Value of the levered equity in the positive scenario is 1550 and 550 in the negative scenario Value of debt in the project today is 400 with an interest rate of 6% Probability of the positive scenario is 45% You can assume perfect capital markets. Now it's your turn to calculate. b) What is the expected return on the debt and levered equity? Answer: We know that the firm won't go bankrupt since the value of the equity in both scenarios is larger than zero. Hence, the expected return on the debt is the interest rate of 6%. The expected return of the equity is 1.550 550 1). 55% = 25% 45% + 800 .800 c) Plot the cost of debt, cost of equity and unlevered cost of capital as a function of the D/V ratio Answer: V E D/E D/V ra 0.186667 0.186667 re 1200 1200 6% 1200 200 1000 0.2 0.166667 6% 0.186667 0.212 1200 400 800 0.5 0.333333 6% 0.186667 0.25 1200 600 600 0.5 6% 0. 186667 0.313333
You are hired as a CFO of the company ABC. ABC has just been through an IPO process. The CEO is about to undertake a new investment project and know that one source of shareholder value is the unlevered cash flow. a) Explain the CEO another source of shareholder value when undertaking a new investment project (Don't worry if you can't answer it now, we will cover on this more in lecture 10) Answer: See exhibit 13.2 at page 435. Back to the project ABC consider undertaking. From the market analysis team you get the following infor- mation: Value of the initial levered equity is 800 Value of the levered equity in the positive scenario is 1550 and 550 in the negative scenario Value of debt in the project today is 400 with an interest rate of 6% Probability of the positive scenario is 45% You can assume perfect capital markets. Now it's your turn to calculate. b) What is the expected return on the debt and levered equity? Answer: We know that the firm won't go bankrupt since the value of the equity in both scenarios is larger than zero. Hence, the expected return on the debt is the interest rate of 6%. The expected return of the equity is 1.550 550 1). 55% = 25% 45% + 800 .800 c) Plot the cost of debt, cost of equity and unlevered cost of capital as a function of the D/V ratio Answer: V E D/E D/V ra 0.186667 0.186667 re 1200 1200 6% 1200 200 1000 0.2 0.166667 6% 0.186667 0.212 1200 400 800 0.5 0.333333 6% 0.186667 0.25 1200 600 600 0.5 6% 0. 186667 0.313333
You are hired as a CFO of the company ABC. ABC has just been through an IPO process. The CEO is about to undertake a new investment project and know that one source of shareholder value is the unlevered cash flow. a) Explain the CEO another source of shareholder value when undertaking a new investment project (Don't worry if you can't answer it now, we will cover on this more in lecture 10) Answer: See exhibit 13.2 at page 435. Back to the project ABC consider undertaking. From the market analysis team you get the following infor- mation: Value of the initial levered equity is 800 Value of the levered equity in the positive scenario is 1550 and 550 in the negative scenario Value of debt in the project today is 400 with an interest rate of 6% Probability of the positive scenario is 45% You can assume perfect capital markets. Now it's your turn to calculate. b) What is the expected return on the debt and levered equity? Answer: We know that the firm won't go bankrupt since the value of the equity in both scenarios is larger than zero. Hence, the expected return on the debt is the interest rate of 6%. The expected return of the equity is 1.550 550 1). 55% = 25% 45% + 800 .800 c) Plot the cost of debt, cost of equity and unlevered cost of capital as a function of the D/V ratio Answer: V E D/E D/V ra 0.186667 0.186667 re 1200 1200 6% 1200 200 1000 0.2 0.166667 6% 0.186667 0.212 1200 400 800 0.5 0.333333 6% 0.186667 0.25 1200 600 600 0.5 6% 0. 186667 0.313333
In question C there is a plot of of cost of debt, cost of equity and cost of capital. Can you show how r_a is calculated to be 0.18667?
r_d = Cost of debt
r_a = cost of capital
r_e = Cost of equity
Transcribed Image Text:Additional Exercise (2)
You are hired as a CFO of the company ABC. ABC has just been through an IPO process. The CEO is about
to undertake a new investment project and know that one source of shareholder value is the unlevered cash
flow.
a) Explain the CEO another source of shareholder value when undertaking a new investment project
(Don't worry if you can't answer it now, we will cover on this more in lecture 10)
Answer: See exhibit 13.2 at page 435.
Back to the project ABC consider undertaking. From the market analysis team you get the following infor-
mation:
Value of the initial levered equity is 800
Value of the levered equity in the positive scenario is 1550 and 550 in the negative scenario
Value of debt in the project today is 400 with an interest rate of 6%
Probability of the positive scenario is 45%
You can assume perfect capital markets. Now it's your turn to calculate.
b) What is the expected return on the debt and levered equity?
Answer: We know that the firm won't go bankrupt since the value of the equity in both scenarios is larger than
zero. Hence, the expected return on the debt is the interest rate of 6%. The expected return of the equity is
(1.550
800
(550
* 45% +
800
-1).
+ 55% = 25%
c) Plot the cost of debt, cost of equity and unlevered cost of capital as a function of the D/V ratio
Answer:
V
D
E
D/E
D/V
r d
ra
0.186667 0.186667
re
1200
1200
6%
1200
200
1000
0.2
0.166667
6%
0.186667
0.212
1200
400
800
0.5
0.333333
6%
0.186667
0.25
1200
600
600
0.5
6%
0.186667 0.313333
Definition Definition Amount of return a company generally pays to its equity investors. The cost of equity represents the compensation required by the market in lieu of owning the asset firm and simultaneously bearing the risk of ownership.
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