Part 1: Company J is considering a project with a 4-year lifespan. The initial cash flow estimate is $125million
in the first year increasing by $125million in each of the years 2 through 4. To begin the project, the company will need to invest $1billion dollars. Company J would like to cover the initial investment amount with existing internal resources and thereby not borrow. As such it remains an all-equity firm. The unlevered cost of its equity is 10%, similar to other firms in the industry sector. There will be no terminal value of significance at the end of year 4. Using the domestic APV equation below, construct a spreadsheet model to determine whether it makes sense for Company J to proceed with this project.
Part 2: Now, imagine that company j finances the project with $600,000,000 of debt at= 8 percent. As such the company becomes a levered firm due to its acquisition of debt. What do the debt and related interest expense mean for the project if the tax rate is 40 percent? Update your spreadsheet model from above to demonstrate the effect of this debt on your decision.
2 Cost of Equity
0 – 1.000.000.000 – 1.000.000.000 – 1.000.000.000