Valuation

a) Raptors Tech has $600,000 of debt on its balance sheet and pays corporate taxes at the 30% rate.
The CEO of Raptors Tech faces an investment opportunity that requires an initial investment of
$50,000 in new machinery and is expected to generate annual cash flows (before tax) of $32,000 for
two years, starting in the first year. At the end of the second year, Raptors will be able to recover a
salvage value of $10,000 by selling the project’s machinery. The unlevered cost of capital is 10%.

What is the value of the project if Raptors Tech decides to issue $30,000 in bonds at an interest
rate of 8% to finance the project? (3 marks)

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b) Lerner Tech is planning to go public and sell 250,000 shares. Lerner Tech’s forecasted EBIT for next
year is $400,000. Lerner Tech has $120,000 debt in the form of bank loans. Penn Tech, a public
company that is similar to Lerner Tech in terms of its productive assets, has 1,100,000 shares
outstanding. Penn Tech’s shares are traded at $6 per share. Penn has $400,000 debt on its balance
sheet and analysts estimated its next year’s EBIT to be $2,500,000. As the underwriter hired to assist
Lerner Tech in its IPO, what price per share would you suggest Lerner Tech to sell its shares at? (3
marks)

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Cost of Capital
Lincoln is a multi-divisional firm involved in a number of infrastructure related projects spanning
construction, engineering design, and power transmission. To finance its growth during this period of
high government spending, corporate bonds are issued that would pay a 6% annual coupon rate. The
firm's debt/equity ratio is 0.7 and its tax rate is 30%.

Since the company is involved with a number of different projects, your supervisor has asked you to use
the pure play approach to estimate the appropriate cost of capital for the construction division. As a
comparison, he has provided you with the following information regarding two of the firm's construction-
focused competitors.

Erik Inc: this year's dividend D0= $1.65, sustainable dividend growth = 4%, stock price = $18.45, D/E = 0.6,
tax rate = 25%, rD = 6%

Krane Inc: Beta = 1.7, D/E = 0.9, Risk-free rate = 2%, expected market return = 10.65%, tax rate = 20%, rD
= 8%

Assuming an absence of distress costs and that the firm maintains its capital structure, while using an
average number based on the two comparable firms, what will be its cost of capital for a project in the
construction division? (6 marks)

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Cost of Capital/Valuation
Wilson Inc. uses bonds and common shares to finance its investments and operations. The firm’s debt
consists of 20,000 bonds that are currently trading at a price of $1,052 each ($21,040,000 debt). Wilson’s
debt level is fixed in perpetuity and the risk of tax shields is the same as the risk of debt. Wilson’s 500,000
common shares are currently trading at a price of $49.05 each. The company’s average tax rate is 40%.
Ignoring distress costs, determine the price per share of Wilson Inc. if it were all equity financed, (i.e. if its
debt was retired by issuing new equity). (2 marks)

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Real Options
Fly Inc. is considering the launch of a new product but there is some uncertainty about how the product
will actually be received. Accordingly your junior analyst has provided you with three sets of market
conditions and estimated the probability of each set of circumstances (we learn after two years what will
happen from that point forward). Starting the project today would incur costs of $14,000,000, the
appropriate cost of capital is 10%.

"Good": The product is very well received and profits are estimated to start at $1,400,000 in year 1 with
30% annual growth for 2 years and then slowing to 1% growth into the foreseeable future (at least 30
years). The probability of this occurring is estimated to be 30%.

"Average": Profits start at $1,300,000 in year 1 and grow continuously at 1% for the foreseeable future.
Probability of occurring is 50%

"Poor": Profits start at $900,000 in year 1 but then drop off by 10% each year into the foreseeable future.
Probability of occurring is 20%.

a) What is the NPV of this project? (3 marks)

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 b) If you wait for two years so that there would be no uncertainty about the project's outcome
before investing, what is the project's NPV? What is the value of the real option to wait?
(3 marks)

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