Chapter 18 Practice Problems
1. MEO Foods, Inc., has made cat food for over 20 years. The company currently
has a debt-equity ratio of 25 percent, borrows at a 10-percent interest rate, and is
in the 40-percent tax bracket. Its shareholders require an 18-percent return.
MEO is planning to expand cat food production capacity. The equipment to be
purchased would last three years and generate the following unlevered cash flows
(UCF):
Year 0:
Year 1:
Year 2:
Year 3:
Year 4+:
-$15 million
+$5 million
+$8 million
+$10 million
$0
MEO has also arranged a $6 million debt issue to partially finance the expansion.
Under the loan, the company would pay 10 percent annually on the outstanding
balance. The firm would also make year-end principal payments of $2 million
per year, completely retiring the issue at the end of the third year.
Ignoring the costs of financial distress and issue costs, what is the APV of the
expansion plans?
2. Milano Pizza Club owns a chain of three identical restaurants for their Milan style
pizza. Each store has a debt-to-equity ratio of 30 percent and makes interest
payments of $25,650 at the end of each year. An equivalent all-equity financed
store would have a discount rate of 15 percent and the cost of debt is 9.5%. For
each store, the estimated annual sales are $1,000,000, costs of goods sold are
$400,000, and overhead costs are $300,000. Each of these cash flow streams is
assumed to be a perpetuity. The corporate tax rate is 40 percent. Using the FTE
approach, what is the value of Milano’s Pizza Club’s equity?
3. Oswego Corporation is a major producer of farm equipment. Oswego stock
currently sells for $36 per share; there are 25 million shares outstanding. Oswego
also has perpetual debt outstanding with an aggregate market value of $600
million and an interest rate of 6%. The risk free rate is also 6%, and the market
risk premium is 8%. Oswego's stock has a beta of 1.75. Oswego is considering a
scale-enhancing project. The project under consideration by Oswego requires an
outlay of $1.5 million. The project generates an annual cash flow before interest
and taxes of $466,666.67 and this cash flow is expected to continue in perpetuity.
The firm’s cash flow is taxed at the 40% rate. Owego will maintain its current
debt ratio while financing the project. Calculate the project’s net present value
using the WACC valuation method.
ANSWERS:
1. $1.78 million
2. $3,088,367.73
3. $583,333.33
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