Construct a pro forma for the following firm: A 3-year project costs $150 in year 1 (not year 0) and produces $70 in year 1, $60 in year 2, and $55 in year 3. (All numbers are year-end.) Depreciation, both real and financial, is straight line over 3 years.
Projects of this riskiness (and with this term structure of project payoffs) have an 18% before-tax opportunity cost of capital. The marginal corporate income tax rate is 40%.
(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.
(d) Assume that this firm expects to receive an extra bonus of $2 in years 2 and 3 from a benevolent donor. What would be the project's cash flows and IRR now? For the remaining questions, assume that the firm instead has a capital structure financing $50 with debt raised in year 1 at a 10% (expected) interest rate. There is no interest paid in year 1, just in years 2 and 3. The principal is repaid in year 3.
(e) Construct the pro forma now. What is the IRR of this project?
(f) From the pro forma, what is the NPV of the debt-financed project?
(g) Compute the NPV via the APV method.
(h) Via the APV method, how much would firm value be if the firm would have taken on not $50, but $40, in debt (assuming the same debt interest rate of 10%)?
(i) Does the debt ratio of the firm stay constant over time? Is this firm a good candidate for the WACC method?