COMM 370

Solutions to Practice Questions for Topic 9: Advanced Valuation and Capital Budgeting

Questions 1-11 are simple questions whose answers are in the notes.
Question 12.
a) The key question is how management sets rh (hurdle rate) relative to r (true cost of capital):

If rh = r, then capital budgeting decisions based on the IRR vs. hurdle rate approach and those
based on the DCF / NPV approach are equivalent (they accept / reject the same projects).
Think of a picture with NPV on the vertical axis and discount rate on the horizontal axis.
This would typically show that NPV decreases as the discount rate increases, often going
from positive to negative NPV as you go from left to right, and crossing the horizontal axis
at the IRR. If IRR > rh = r, then NPV > 0 at the true cost of capital r (to reduce NPV to zero,
you must overstate the cost of capital). Both approaches say “do the project”. Conversely, if
IRR < rh = r, then NPV < 0 at the true cost of capital r (to increase NPV to zero, you must
understate the cost of capital). Both approaches say “don’t do the project”.

If rh > r, then it could reject some projects with positive NPV: those for which r < IRR < rh.
If rh < r, then it could accept some projects with negative NPV: those for which rh < IRR < r.
In these two cases, the hurdle rate approach is problematic, because the hurdle rate does not
reflect the true cost of capital (a man-made error!). This matters in practice, because
managers might not revise rh frequently, making the approach prone to errors (think about
inertia in organizations!).

Last, people would argue that managers typically set rh > r (rather than the opposite), so while
they might reject some positive NPV projects, they would most frequently accept those that
generate larger NPVs. However (and this this beyond the scope of this question), this is not
always true. In fact, you can have high IRR projects with low dollar NPVs (small projects)
and low IRR but high dollar NPVs (large projects), so one has to be careful with this
reasoning: it might be the approach rejects positive NPV projects with large dollar NPVs but
low IRRs…just for you to be aware of this possibility.

b) Because rh is only appropriate to evaluate projects with average project risk, decisions for
projects with risk above or below the average will be distorted relative to those based on rp.
Amaroc will systematically tend to reject projects with low risk and thus a low rp: some
positive NPV projects can have rp < rh, and thus have an rp < IRR < rh. It will also tend to
accept projects with high risk and thus a high rp: some negative NPV projects can have rp >
rh, and thus have an rh < IRR < rp.

Note: the single hurdle rate approach is similar to using rh to discount the cash flows for all
projects, regardless of their true risk measured by rp. Hence, you will overstate the NPV of
projects with above average risk using a discount rate that is too low (rp > rh) and understate
the NPV of projects with below average risk using one that is too high (rp < rh).

Bottom line: these are widespread practices and for good reasons, BUT be aware of the
potential problems and limitations if you blindly follow this approach.

1
 COMM 370

Question 13.

It is tempting to use the chemical firm’s WACC and compute the project’s NPV, but this is
conceptually wrong. The reason is that although both the firm and the project will have the
same business risk (same line of business), they are different in capital structure and thus
have different financial risk. So, although the firm is a good comparable for the project, we
cannot use its WACC to compute the NPV of the project. The right discount rate for the
project would be the chemical firm’s unlevered cost of capital, but we cannot compute it here
without more information. What we do know is that for the chemical firm, rWACC < rU, so if
we compute the project’s NPV using WACC we will overestimate the NPV of the project.
Intuitively, the firm’s WACC is low because leverage generates tax shields, but the project
will not generate any tax shields as it is all-equity financed. All we can say is that the project’s
NPV is less than –$10M + $1M/.2 = –$5M < 0. Therefore, the firm should not undertake the
project.

Question 14.

The project is financed with only equity, so we must estimate its unlevered cost of capital rU.
The clear advantage of using Atrax is that it has exactly the same business risk as the project,
while Farmco is in a different business and so its business risk will likely differ significantly
from the business risk of the project. You might think an advantage of using Farmco is that
it is already an all-equity company, so its cost of capital provides a direct estimate of rU. In
contrast, in the case of Atrax, we would have to estimate its rU from its observed rE using the
levering-delevering formulas, which may not be fully accurate. Still, given the potentially
large differences in the business risk of suppliers of parts for the car racing industry and for
the farming equipment industry, you would naturally use Atrax Corp to estimate its project’s
rU using some of the levering/delivering formulas. Any inaccuracy of the formulas is likely
small compared to errors due to potentially larger differences in the unlevered risk of the
underlying businesses.

Question 15.

rWACC = (1/2)×6%×(1 – .40) + (1/2)×12% = 7.8%

Project value = $5M / .078 = $64.103M

NPV = $64.103M – $50M = $14.103M

New debt financing = (1/2)×$64.103M = $32.051M

Increase in equity value = (1/2)×$64.103M = $32.051M

$14.103M increase due to NPV
$32.051M – $14.103M = $17.948M is new equity issuance
Note that $17.948M + $32.051M = $50M (amount required for investment)

2
 COMM 370

Question 16.

This is easy, and should be done using the growing perpetuity formula, but be careful with
the timing. FCF in year 11 = $16M×1.04 = $16.64M and this grows at a rate of 4% per year
going forward:
 $16.64 
(1.10) −10 × PV10 (FCF yrs 11+) =
TV0 = (1.10) −10 ×  =$106.924M
 (.10 − .04) 

Note: TV0 is the terminal value as of date zero based on FCF from year 11 into infinity and
PV10 is the present value as of year 10 of the FCF from year 11 into infinity. So, like any
cash flow in year 10, PV10 must be discounted back to date zero!

Question 17.1

Note that with no depreciation, capital expenditures, or interest, Triton’s dividend (cash flow
from operations) is simply: Div2020 = $40Mx(1-.3) = $28M. This dividend will grow together
with EBITDA at 4% per year subsequently. With a cost of capital of 8%, Triton’s value is:

V2019 = $28M / (.08 - .04) = $700M

Question 17.2.

a) It is not practical to calculate this. The D/V ratio is decreasing over time, so the capital
structure weights in both WACC and rE need to be computed each future year.

b) APV is easiest: we know rU and FCF, and PV(ITS) is easy to compute when the debt level
is constant because ITS have the same risk a debt so can be discounted at rD.

V2019 = VU + PV(ITS) = $700M + $200x.06x.3 / .06

= $700M + $60M = $760M

Question 17.3.

a) APV is hard to implement when the debt ratio is constant. The firm value V will change
over time, so the amount of debt required to keep D/V constant will vary over time in
proportion to future firm value. Since we don’t know future firm value, then we don’t know
the amount of debt or the associated interest tax shields.

b) WACC is easiest: we know FCF and need rWACC; we know rD, so to compute rWACC we
are missing rE…We know that rE will be higher than rU = 8% (MM2 intuition), but how
much?

If D/(D+E) = 25.32%, then (D+E) / D = 1 / 25.32%; so 1 + E/D = 3.95 and D/E = 0.3390.

3
 COMM 370

rE = rU + (D/E)(rU-rD) = 8% + 0.3390x(8% - 6%) = 8.68%. This levering/delivering formula

applies when the firm maintains a constant D/V, and is slightly different from the MM2
formula derived when the firm maintains a constant debt level – see appendix in the notes.

rWACC = 8.68% x (1 - 25.32%) + 6% x 25.32% x (1- .3) = 7.54%

V2019 = $28M / (.0754 - .04) = $790M

c)

Capital Structure Rebalancing to keep a D/V=25.32% constant

($Million) 2019 2020 2021 2022 2023

FCF 0.0 28.0 29.1 30.3 31.5
PV(FCF,7.54%) 790.0 821.6 854.5 888.6 933.1
Debt Capacity 200.0 208.0 216.3 225.0 236.2
Debt Issuance 200.0 8.0 8.3 8.7 11.2
Debt Ratio 25.32% 25.32% 25.32% 25.32% 25.32%

Note in 2019 Triton must issue $200M in debt, same amount as in 17.2. But each subsequent
year Triton must issue increasing amounts of debt to keep D/V constant as V increases.

Question 17.4.

When it keeps the debt level constant V2019 = $760M

When it keeps the debt ratio constant V2019 = $790M

Value is higher when Triton keeps D/V constant (opposite of what we saw in the example in
the class notes!). Why? With constant D/V, the ITS are now more risky (in fact should be
discounted at rU = 8%!), which reduces their value, BUT the ITS are growing over time at
4% (same as cash flows and firm value). The second effect (more dollar ITS over time)
dominates the first effects (more risky ITS that increase their discount rate), leading to higher
value of ITS overall. To see this:

Recall VU = $700M

With constant debt level: PV(ITS) = $200 x .06 x .3 / .06 = $60M ; so VL = $760M

With constant debt ratio: PV(ITS) = $200x.06x.3 / (.08 - .04) = $90M ; so VL = $790M

4
 COMM 370

Question 18.

Since D/E=2/3, then D/V=2/5 and E/V=3/5

rWACC = (2/5)×5%×(1 – .40) + (3/5)×10% = 7.2%

1 − (1.072) −3 
Project Value $50M
= =   $130.738M
 .072 

NPV = $130.738M – $100M = $30.738M

Rebalancing and debt capacity:

$ Million Year 0 Year 1 Year 2 Year 3

FCF -100 50 50 50
VL @ WACC = 7.2% 130.738 90.151 46.642 0
Debt capacity w/ D/V=2/5 52.295 36.060 18.657 0.000
Net debt issuance 52.295 -16.235 -17.404 -18.657
Equity w/ D/V=2/5 78.443 54.091 27.985 0.000
NPV 30.738
Net Equity issuance 47.705 -24.352 -26.106 -27.985

Question 19.

In this case, the risk of the tax shields will be roughly the same as the risk of debt, since you
get the tax shields as long as you are able to pay interest. So we discount interest tax shields
at the cost of debt.

Question 20.

a) PVU = $2M / .15 = $13.333M ; and thus NPVU = –$15M + $13.333M = –$1.667M < 0

The project is negative NPV if all-equity financed; so don’t do it!

b) Debt has a fixed schedule and so the right discount rate for interest tax shields is the cost
of debt (10%).

Annual interest tax shield = .1×$10M×.40 = $0.4M

1 − (1.10) −12 
=PV(ITS) $0.4M
=   $2.725M
 .10 

c) NPV = PVU + PV(ITS) = –$15M + $13.333M + $2.725M = $1.058M

NPV with debt financing is positive, so you should take on the project.

5
 COMM 370

Question 21.

a) Calculate the free cash flow:

$ Million Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Incremental earnings forecast

Sales 0.00 25.00 25.00 25.00 25.00 25.00
COGS 0.00 -15.00 -15.00 -15.00 -15.00 -15.00
Gross profit 0.00 10.00 10.00 10.00 10.00 10.00
Operating expenses 0.00 -2.00 -2.00 -2.00 -2.00 -2.00
Depreciation 0.00 -3.00 -3.00 -3.00 -3.00 -3.00
EBIT 0.00 5.00 5.00 5.00 5.00 5.00
Income taxes at 40% 0.00 -2.00 -2.00 -2.00 -2.00 -2.00
Unlevered NI 0.00 3.00 3.00 3.00 3.00 3.00

Free cash flow

+ Depreciation 0.00 3.00 3.00 3.00 3.00 3.00
- CapEx -15.00 0.00 0.00 0.00 0.00 0.00
- Increase in NWC 0.00 0.00 0.00 0.00 0.00 0.00
FCF -15.00 6.00 6.00 6.00 6.00 6.00

b) The all-equity value (net of cost) is:

1 − (1.10) −5 
NPVU =
−$15M + $6M  =$7.74M
 .10 
Yes, do it since NPV>0.

c) The value of the financing comes from the interest tax shields.

$ Million Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Interest tax shields

Debt schedule 13.00 9.00 5.00 3.00 1.00 0.00
Interest 0.00 0.65 0.45 0.25 0.15 0.05
Interest tax shields (𝜏𝜏 =40%) 0.00 0.26 0.18 0.10 0.06 0.02
PV(ITS) 0.56

d) If the loan is taken, then

PV(ITS) = 0.26(1.05) −1 + 0.18(1.05) −2 + 0.10(1.05) −3 + 0.06(1.05) −4 + 0.02(1.05) −5 = $0.56M
NPV = $7.74M + $0.56M = $8.3M
Yes, Medtronic should take on the project if it is going to be financed with a loan. Medtronic
should take the loan because this adds value through tax shields.

e) No! The D/V is changing all the time and thus WACC is complicated. It is easier to use
APV which works well with a fixed debt schedule!

6
 COMM 370

Question 22.

Since debt has a fixed schedule and it is scheduled to decline rapidly over time, the best
method to use is APV. Given that capital structure is changing rapidly over time, WACC is
hard to implement.

APV = PVU + PV(ITS)

PVU = $1billion / (.15 – .05) = $10 billion

$billion Year 0 Year 1 Year 2 Year 3 Year 4

Debt schedule 4 3 2 1 0
Interest 0 0.4 0.3 0.2 0.1
Interest tax shields 0 0.16 0.12 0.08 0.04
Principal repaid 0 1 1 1 1

Because the debt follows a fixed schedule, we discount the interest tax shields at the cost of
debt (10%).

PV(ITS) = 0.16(1.10) −1 + 0.12(1.10) −2 + 0.08(1.10) −3 + 0.04(1.10) −4 = $0.332Billion

APV = $10 billion + $0.332 billion = $10.332 billion

NPV = $10.332 billion – $5 billion = $5.332 billion