In-Class Assignment 9

October 22

This is a more extensive in-class assignment than we’ve done thus far in class. To solve
the two problems, you will need to use Excel.

1. Valuing Companies with APV

Stonecold, Inc. has decided to divest one of its divisions. The assets of the group
have the same operating risk characteristics as those of the parent firm. The capital
structure for the parent has been stable at 35% debt/65% equity (in market-value terms),
the level determined to be optimal given the firm’s assets. The required return on
Stonecold’s assets is 16%, and the firm (and the division) borrows at a rate of 10%.
Stonecold, Inc. currently has $15 million of debt outstanding supporting the division
(note that this is not a perpetual quantity).
Last year’s sales revenue for the division was $19,740,000. Sales revenue is
expected to grow by 8% for the next five years and then grow by the long-term inflation
rate (2%) in perpetuity. Variable costs amount to 60% of sales. Annual depreciation of
$1.8 million is exactly matched each year by new investment in the division’s equipment.
Net working capital is estimated to be 10% of sales. The division would be taxed at the
parent’s current rate of 40%.

a.) WACC approach

Recall that when using the WACC approach, our goal is to calculate the firm’s unlevered
cash flows. By then discounting these cash flows at the firm’s weighted average cost of
capital (WACC), we arrive at a total firm value. To find the value of shareholder equity,
we deduct the value of the firm’s debt.

b.) APV Approach:

The key difference between WACC and APV is that the APV method does not account
for the debt through the inclusion of its cost in the firm’s WACC (that is then used as the
discount rate). Instead, the debt’s impact is included by adding the present value of the
tax subsidy of debt (found by discounting at the cost of debt) to the value of the firm’s
unlevered cash flows (found by discounting at the firms unlevered cost of equity). Much
of the work is similar to that shown above.

For an example of the APV calculation, assume that debt is expected to be $15 million
for the first five years and then in years six through infinity will be $20 million. Ignore
the weights of debt and equity given in the setup previous to the WACC calculation. Also
assume the $15 million in debt is specific to the division.
2. Project Financing

Bicksler Enterprises is considering a $10 million project that will last five years, implying
straight-line depreciation per year of $2 million. The cash revenues less cash expenses
per year are $3,500,000. The corporate tax bracket is 34 percent. The cost of unlevered
equity is 16 percent.

a.) Assume the project is financed with all equity. Find the NPV.

b.) Now assume than Bicksler Enterprises can obtain a five-year, nonamortizing loan
for $7,500,000 after flotation costs at the risk-free rate of 10 percent. Flotation
costs are fees paid when stock or debt is issued. These fees may go to printers,
lawyers, and investment bankers, among others. Bicksler Enterprises is informed
that flotation costs will be 1 percent of the gross proceeds of its loan. Find the
NPV using the APV approach.

c.) Suppose that the project of Bicksler Enterprises is deemed socially beneficial and
the state of New Jersey grants the firm a $7,500,000 loan at 8 percent interest. In
addition, all flotation costs are absorbed by the state. Now what is the NPV of the
project?