Chapter 12, Problem 25P

Your company operates a steel plant. On average, revenues from the plant are $30 million per year. All of the plants costs are variable costs and are consistently 80% of revenues, including energy costs associated with powering the plant, which represent one quarter of the plant’s costs, or an average of $6 million per year. Suppose the plant has an asset beta of 1.25, the risk-free rate is 4%, and the market risk premium is 5%. The tax rate is 40%, and there are no other costs.

1. a. Estimate the value of the plant today assuming no growth.
2. b. Suppose you enter a long-term contract which will supply all of the plant’s energy needs for a fixed cost of $3 million per year (before tax). What is the value of the plant if you take this contract?
3. c. How would taking the contract in (b) change the plant's cost of capital? Explain.