a) You are the CEO of a highly profitable firm and you expect the firm to remainsuccessful and profitable in the future. Currently, you are evaluating a new,large investment project that could be initiated at the start of 2022. The projectinvolves the purchase of a real estate asset requiring an initial outlay of £650million. You expect that, over the first five years of the project, its initial capitalinvestment should be fully depreciated. Your accountants have prepared thefollowing projections on expected sales and cash flows (in millions), andinformation on the cost of capital of your company:Table 1. Sales and cash flow projections20222023202420252026Sales80115104155140143136EBITD72130122(130)(58)(10.44)(47.56)(130)(26)(4.68)(21.32)DepreciationЕBIT(130)10(130)(130)(8)(1.44)(6.56)Тах еxpensе1.8ΕΒΙΑΤ8.2Table 2. Cost of capitalRisk-free Rate (Rf)Project Cost of Debt (Rd)Market Risk Premium1%4%6%Statutory and Marginal Corporate Tax 18%Rate (Tc)AssetBetaofComparable 0.8CompaniesAddress the following questions, always assuming that cash flows occur at theend of their respective years:(i) Estimate the NPV of the investment project at the start of 2022, if it is100% financed with equity and assuming that the project is terminated atthe end of 2026. Describe your calculations and comment on yourfindings.(ii) Use the WACC method to estimate the NPV of the investment at thestart of 2022, assuming that it is financed 25% with equity and 75% withdebt and that the project is terminated at the end of 2026. Describe yourcalculations and comment on your findings. (iii) You have just realised that, in the previous calculations, you have notconsidered two important items, namely, the changes in working capitalover time and the salvage value of the real estate asset at the end of theproject. You expect to sell this asset at the end of 2026 for £120 million.In terms of working capital, an investment of £15 million is required at thestart of the project and the level of working capital at the end of each yearis expected to be as follows:20222023202420252026Level of workingсapital18252522Recalculate the NPV of the project in part (ii) above, also considering theworking capital investments and the salvage value of the asset. Describeyour calculations and comment on your findings.(iv) The WACC method that you have applied above is popular amongfirms, but what are the main assumptions behind this method? Are theseassumptions plausible in light of the empirical evidence you are aware of?An alternative to the WACC method is the APV method. When is the APVmethod preferable to the WACC method in practical applications? [Wordlimit: 350 words](v) In this question, we assume that your firm's marginal corporate tax rateis equal to the statutory corporate tax rate set in the law. Is this a fairassumption in consideration of the current and expected profitability ofyour firm?Assume that your firm has made large losses both in the past and in thecurrent period and is not expected to be highly profitable in the next fiveto ten years. Describe which calculations in part (ii) are likely to be affectedby these changes in assumptions and in which way. [Word limit: 150words]b) The variables that correlate with a firm's leverage have been studied by manyresearchers over the years. While the set of statistically significant variablesmay vary from study to study, the following is a list of the common determinantsof capital structure:- Firm size;- Asset tangibility;- Profitability;- Market-to-book (MTB) ratio;- Industry capital structure.For each of these variables, describe the sign (positive or negative) of therelationship that is typically observed with leverage. Also, explain whether sucha relationship is expected based on the trade-off theory, the pecking ordertheory or other theories of capital structure. [Word limit: 500 words]

Answered: Image /qna-images/answer/3768821d-cd62-49e6-83c2-1cbbe0c080ea.jpg

a) You are the CEO of a highly profitable firm and you expect the firm to remain successful and profitable in the future. Currently, you are evaluating a new, large investment project that could be initiated at the start of 2022. The project involves the purchase of a real estate asset requiring an initial outlay of £650 million. You expect that, over the first five years of the project, its initial capital investment should be fully depreciated. Your accountants have prepared the following projections on expected sales and cash flows (in millions), and information on the cost of capital of your company: Table 1. Sales and cash flow projections 2025 2022 2023 2024 2026 Sales 80 115 104 155 140 143 136 EBITD 72 130 122 (130) (58) (10.44) (47.56) (130) (26) (4.68) (21.32) (130) Depreciation ЕBIT (130) 10 (130) (8) (1.44) (6.56) Тах еxpensе ΕΒΙΑΤ 1.8 8.2 Table 2. Cost of capital Risk-free Rate (Rf) Project Cost of Debt (Rd) Market Risk Premium 1% 4% 6% Statutory and Marginal Corporate Tax 18% Rate (Tc) Asset Beta of Comparable 0.8 Companies Address the following questions, always assuming that cash flows occur at the end of their respective years: (i) Estimate the NPV of the investment project at the start of 2022, if it is 100% financed with equity and assuming that the project is terminated at the end of 2026. Describe your calculations and comment on your findings. (ii) Use the WACC method to estimate the NPV of the investment at the start of 2022, assuming that it is financed 25% with equity and 75% with debt and that the project is terminated at the end of 2026. Describe your calculations and comment on your findings.

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS