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For examples 1 and 2, assume the net cash flow is 2,000,000, the tax rate is 40% and the cost of common equity is 10% which is computed using the CAPM equation. Explain in a few sentences what each example means.

For examples 1 and 2, assume the net cash flow is 2,000,000, the tax rate is 40% and the cost of common equity is 10% which is computed using the CAPM equation. Explain in a few sentences what each example means.

Essentials Of Investments
Essentials Of Investments
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
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For examples 1 and 2, assume the net cash flow is 2,000,000, the tax rate is 40% and the cost of common equity is 10% which is computed using the CAPM equation. Explain in a few sentences what each example means.
## Example 1: Value of Common Equity in an All-Equity Firm Assume that the common equity shareholders have financed the asset entirely with $10 million of equity capital. We can determine the value of the common equity investment to the shareholders using the present value of free cash flows for common equity shareholders. The free cash flow to common equity shareholders each year will be as follows: - **Net Cash Flow**: $2,000,000 - **Income Taxes**: 0.40 × $2,000,000 = $800,000 - **Free Cash Flow for Common Equity Shareholders**: $1,200,000 The value to the shareholders of the common equity in the firm is $12,000,000 (= $1,200,000/0.10). Dividing by the discount rate is appropriate because the $1.2 million annual free cash flow for common equity is a perpetuity with no growth. This investment is worth $12 million to those shareholders (a gain of $2 million over the original investment of $10 million) because of the present value of the free cash flows the investment will generate and that will in turn be paid out as dividends to the shareholders. Therefore, we would determine the same value for the investment using the dividends-based valuation model as shown in Example 5 in Chapter 11. ## Example 2: Value of Common Equity in a Firm with Debt Financing For this example, we will make the same assumptions as in the preceding example, except we will now make the following additional assumptions to use both debt and equity financing: - The equity shareholders finance a portion of the investment in the asset with $4 million of equity capital. - The firm finances the remainder of the asset using $6 million of debt capital. - This amount of debt in the firm’s capital structure does not alter substantially the risk of the firm to the equity investors, so they continue to require a 10 percent rate of return. - The debt is issued at par, and it is less risky than equity; so the debtholders demand interest of only 6 percent each year, payable at the end of each year. - Interest expense is deductible for income tax purposes. We can again determine the value of the common equity investment using the present value of the free cash flows for common equity shareholders.
Transcribed Image Text:## Example 1: Value of Common Equity in an All-Equity Firm Assume that the common equity shareholders have financed the asset entirely with $10 million of equity capital. We can determine the value of the common equity investment to the shareholders using the present value of free cash flows for common equity shareholders. The free cash flow to common equity shareholders each year will be as follows: - **Net Cash Flow**: $2,000,000 - **Income Taxes**: 0.40 × $2,000,000 = $800,000 - **Free Cash Flow for Common Equity Shareholders**: $1,200,000 The value to the shareholders of the common equity in the firm is $12,000,000 (= $1,200,000/0.10). Dividing by the discount rate is appropriate because the $1.2 million annual free cash flow for common equity is a perpetuity with no growth. This investment is worth $12 million to those shareholders (a gain of $2 million over the original investment of $10 million) because of the present value of the free cash flows the investment will generate and that will in turn be paid out as dividends to the shareholders. Therefore, we would determine the same value for the investment using the dividends-based valuation model as shown in Example 5 in Chapter 11. ## Example 2: Value of Common Equity in a Firm with Debt Financing For this example, we will make the same assumptions as in the preceding example, except we will now make the following additional assumptions to use both debt and equity financing: - The equity shareholders finance a portion of the investment in the asset with $4 million of equity capital. - The firm finances the remainder of the asset using $6 million of debt capital. - This amount of debt in the firm’s capital structure does not alter substantially the risk of the firm to the equity investors, so they continue to require a 10 percent rate of return. - The debt is issued at par, and it is less risky than equity; so the debtholders demand interest of only 6 percent each year, payable at the end of each year. - Interest expense is deductible for income tax purposes. We can again determine the value of the common equity investment using the present value of the free cash flows for common equity shareholders.
### Example 2: Value of Common Equity in a Firm with Debt Financing For this example, we will make the same assumptions as in the preceding example, except we will now make the following additional assumptions to use both debt and equity financing: - **The equity shareholders finance a portion of the investment in the asset with $4 million of equity capital.** - **The firm finances the remainder of the asset using $6 million of debt capital.** - This amount of debt in the firm’s capital structure does not alter substantially the risk of the firm to the equity investors, so they continue to require a 10 percent rate of return. - The debt is issued at par, and it is less risky than equity; so the debtholders demand interest of only 6 percent each year, payable at the end of each year. - **Interest expense is deductible for income tax purposes.** We can again determine the value of the common equity investment using the present value of free cash flows for common equity shareholders. Note that this example is essentially the same as Example 6 in Chapter 11, except that the valuation focus changes from dividends to free cash flows. The free cash flow available to common equity shareholders each year is as follows: | Calculation | Amount | |-------------|---------| | Net Cash Flow for All Debt and Equity Capital | $2,000,000 | | Interest Paid on Debt: 0.06 × $6,000,000 | (360,000) | | Income Taxes: 0.40 × ($2,000,000 - $360,000) | (656,000) | | **Free Cash Flow for Common Equity Shareholders** | **$984,000** |
Transcribed Image Text:### Example 2: Value of Common Equity in a Firm with Debt Financing For this example, we will make the same assumptions as in the preceding example, except we will now make the following additional assumptions to use both debt and equity financing: - **The equity shareholders finance a portion of the investment in the asset with $4 million of equity capital.** - **The firm finances the remainder of the asset using $6 million of debt capital.** - This amount of debt in the firm’s capital structure does not alter substantially the risk of the firm to the equity investors, so they continue to require a 10 percent rate of return. - The debt is issued at par, and it is less risky than equity; so the debtholders demand interest of only 6 percent each year, payable at the end of each year. - **Interest expense is deductible for income tax purposes.** We can again determine the value of the common equity investment using the present value of free cash flows for common equity shareholders. Note that this example is essentially the same as Example 6 in Chapter 11, except that the valuation focus changes from dividends to free cash flows. The free cash flow available to common equity shareholders each year is as follows: | Calculation | Amount | |-------------|---------| | Net Cash Flow for All Debt and Equity Capital | $2,000,000 | | Interest Paid on Debt: 0.06 × $6,000,000 | (360,000) | | Income Taxes: 0.40 × ($2,000,000 - $360,000) | (656,000) | | **Free Cash Flow for Common Equity Shareholders** | **$984,000** |
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