Lab 7

DIABLO

Diablo has a network of motorcycle repair shops. As its owner are risk averse, the firm
financing relied up to now on shareholders equity alone. Accordingly, Diablo has no debt
in its capital structure. It has 5 million common shares outstanding and the share price
on the market is $20. Its equity total market value it therefore $100 million. As there are
not debt, it also is the firm total market value.

Annual earnings before interest and taxes (EBIT) is $16 million. Diablo’s tax rate is
25 %. The dividend policy is to pay 100 % of net earnings to shareholders. Therefore, no
growth is expected in the future. For the sake of simplicity, we will treat this EBIT as a
perpetuity.

A) Determine the shareholders required rate of return (Ks).

Diablo analyses an investment project. Its risk is very similar to actual operations.
Capital needed is $20 million and it would generate an EBIT of $5 million per year.

B) Estimate the project net present value (NPV) using the appropriate discount rate.

C) Assuming the capital needed for the project ($20 million) is raised by issuing new
common shares, determine what should be the new market value for Diablo.

D) How many shares will the firm has to issue to raise the capital needed?

Management realize it could use debt to finance this project. As the firm is more mature,
lenders are willing to offer better conditions for a long term loan. Diablo’s bank as offered
to finance the investment with a perpetual loan (i.e. no maturity) with an interest rate of 8
%.

E) Compute the firm’s total market value assuming the financing is done with the
bank.

F) In this context, determine the market value for total equity.

G) What would be the value per share in this case?

H) Determine the new required rate of return in this context.

I) Compute the weighted average cost of capital (WACC) with the new capital
structure.

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 J) A second project, identical to the first one, is also possible. Management ask you
to compute its NPV using the WACC as the discount rate.

K) How is your answer different from question B? What do you notice?

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