Construct a pro forma for the following firm: A 4-year project costs $150 in year 1 (not year 0) and produces $70 in year 1, $60 in year 2, $50 in year 3, and $40 in year 4. (All numbers are year-end.) Depreciation, both real and financial, is straight line over 4 years. Projects of this riskiness (and with this term structure of project payoffs) have a 15% taxable cost of capital. The marginal corporate income tax rate is 33%.
(a) Assume that the firm is 100% equity- financed. Construct the pro forma and compute expected project cash flows.
(b) Compute the project IRR.
(c) Compute the project NPV. For the remaining questions, assume that the firm instead has a capital structure financing $100 with debt raised in year 1 at a 10% (expected) interest rate. Interest is paid out in each year. Principal and interest are paid out in the final year. Money in excess of interest payments is paid out as dividends.
(d) Construct the pro forma now. What is the IRR of this project?
(e) From the pro forma, what is the NPV of the debt-financed project?
(f) Compute the NPV via the APV method.
(g) Via the APV method, how much would firm value be if the firm would have taken on not $100, but $40, in debt (assuming the same interest rate of 10%)?
(h) Does the debt ratio of the firm stay constant over time? Is this firm a good candidate for the WACC method?