COMM370 Ting Xu

Practice for Lecture 8: Capital Budgeting with Debt

Question 1. Lululemon Athletica (Lulu) is considering the opening of a new store in the
greater Vancouver area. The project requires an initial investment of $50M and is expected
to produce $5M in annual FCFs forever. All of Lulus debt is perpetual, and the firm
continuously rebalances its capital structure to maintain a target D/E = 1. Lulus corporate
tax rate is 40%. Its cost of debt is 6% and its cost of equity is 12%.

a) Calculate the projects value and NPV using the WACC method. As part of your answer
explain how the project will be financed and how Lulu will keep its capital structure
constant.

b) Calculate the projects equity value, total value, and NPV using the FTE method.
Assume the firm will issue $32.051M in new perpetual debt at 6%.

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c) Calculate the projects value and NPV using the APV method. Assume you dont know

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the amount of debt the firm will issue. What is the value created by the debt financing?

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Solution

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a) WACC Method

rWACC = (1/2) x 6% x (1-.40) + (1/2) x 12% = 7.8%

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

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NPV = $64.103M - $50M = $14.103M

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

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

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$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)
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b) FTE Method assuming the firm will issue $32.051M in new perpetual debt.
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LCF = $5M - $32.051M x 6% x (1-.40) = $3.846M

Recall rE = 12%

E = $3.846M/.12 = $32.051M

V = $32.051M + $32.051M = $64.103M

NPV = $64.103M - $50M = $14.103M

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 COMM370 Ting Xu

OR
NPV = $32.051M ($50M - $32.051M) = $14.103M

c) APV Method, and lets pretend we dont know the amount of debt Lulu will issue.

rU = (1/2) x 6% + (1/2) x 12% = 9%

VU = $5M / .09 = $55.556M

Recall that because the firm keeps D/E constant, the risk of the interest tax shields is the
same as the risk of the project and so interest tax shields should be discounted at rU. We
need to solve for the levered project value and amount of debt simultaneously:

D/V = 1/2

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V = $55.556M + [.06 x D x .4] / .09

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Solving we get V = $64.103M and D = $32.051.

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The value created by the debt financing is the present value of the interest tax shields

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$64.103M - $55.556M = $8.547.
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Question 2. Alumex, a large producer of aluminum, is considering building a new
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aluminum plant to satisfy a recent increase in demand. The project requires an initial
investment of $120M and is expected to produce $5M in annual FCFs forever. All of
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Alumexs debt is perpetual, and the firm continuously rebalances its capital structure to
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maintain a target D/E = 3. Alumexs corporate tax rate is 40%. Its cost of debt is 5% and its
cost of equity is 10%.
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a) Calculate the projects value and NPV using the WACC method. As part of your answer
explain how the project will be financed and how Alumex will keep its capital structure
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constant.

b) Calculate the projects value and NPV using the FTE method. Assume you dont know
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how much debt the firm will issue.

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c) Calculate the projects value and NPV using the APV method. Assume you dont know
how much debt the firm will issue. What is the value created by the debt financing?

Solution

a) WACC Method

rWACC = (3/4) x 5% x (1-.40) + (1/4) x 10% = 4.75%

Project value = $5M / .0475 = $105.263M

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 COMM370 Ting Xu

NPV = $105.263M - $120M = -$14.737M

New debt financing = (3/4) x $105.263M = $78.947M

Increase in equity value = (1/4) x $105.263M = $26.316M

-$14.737M decrease due to negative NPV
$26.316M (- $14.737M) = $41.053M is new equity issuance
note that $78.947M + $41.053M = $120M (amount required for investment)

b) FTE Method, and lets pretend we dont know the amount of debt Alumex will issue.
Note in this question I am asking you to solve simultaneously for value and debt and that
the two of them are related by the firms capital structure. So this questions is just to
illustrate how this would work, but note this is very similar to what you do in the case of

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APV in c) of this question.

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LCF = $5M D x .05 x .6 = $5M Dx.03

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(1) E = ($5M Dx.03) / .1

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(2) D/E = 3
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Plug (2) into (1): .1 x E = 5M 3xEx.03 ; solving we get E = $26.316M
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Plug E= into (2) to get D = $78.947M

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Thus V = $26.316M + $78.947M = $105.263M

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NPV = $105.263M $120M = -$14.737M

OR
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NPV = $26.316M ($120M - $78.947M) = -$14.737M

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c) APV Method, and lets pretend we dont know the amount of debt Alumex will issue.

rU = (3/4) x 5% + (1/4) x 10% = 6.25%

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VU = $5M / .0625 = $80M

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Recall that because the firm keeps D/E constant, the risk of the interest tax shields is the
same as the risk of the project and so interest tax shields should be discounted at rU. We
need to solve for the levered project value and amount of debt simultaneously:

D/V = 3/4
V = $80M + [.05 x D x .4] / .0625

Solving we get V = $105.263M and D = $78.947M.

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 COMM370 Ting Xu

Question 3. Gentex, a large producer of light bulbs, is considering building a small factory
to expand its productive capacity. After completion, the factory will operate for one year to
meet a temporary increase in demand, but after that the factory will be abandoned with no
salvage value. The factory requires an initial investment of $50M (at year 0) and is
expected to produce $80M in the first and only year of production (year 1). Gentex
continuously rebalances its capital structure to maintain a target D/E = 1. Gentexs
corporate tax rate is 40%. Its cost of debt is 4% and its cost of equity is 8%.

a) Calculate the projects value and NPV using the WACC method. Explain how Gentex
will rebalance its capital structure and calculate the projects annual debt capacity.

b) Calculate the projects value and NPV using the APV method. Assume you dont know
the projects annual amount of debt. Simultaneously solve for the amount of debt and
project value in each year.

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Solution

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a) WACC Method

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rWACC = (1/2) x 4% x (1-.40) + (1/2) x 8% = 5.2%
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Project value = $80M /1.052 = $76.046M
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NPV = $76.046M - $50M = $26.046M

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$ Million Year 0 Year 1

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FCF -50.000 80.000

VL @ WACC = 5.2% 76.046 0.000
Debt capacity w/ D/V=1/2 38.023 0.000
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Net debt issuance 38.023 -38.023

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Equity w/ D/V=1/2 38.023 0.000

NPV 26.046
Net equity issuance 11.977 -11.977
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Note that the project generates debt capacity in year zero only, so you need to issue debt
and equity in year zero but you have to retire debt and equity in year 1.

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 COMM370 Ting Xu

b) APV Method and lets pretend this is how we started, so we dont know the amount of
debt Gentex will issue.

Calculate rU = (1/2) x 4% + (1/2) x 8% = 6%

Calculate the unlevered project value:

VU = $80M / 1.06 = $75.472M

Now we would need to calculate the value of the interest tax shields, but for that we need to
know the amount of debt and we dont know it. We have to solve for the amount of debt
and project value simultaneously. Again, we know that the project generates value and debt
capacity only in year 0; debt capacity is zero in year 1. So we need to calculate the amounts
of debt and equity issued in year 0 and then we know that in year 1 we need to retire debt

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and equity by the amounts increased in year 0. Lets do it:

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V = 75.472M + .04 x .4 x D / 1.06

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D/V = 1/2 or D = V/2

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Solving we get V = $76.046M, and D = $38.023M, and E = $38.023M.
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NPV = $76.046M - $50M = $26.046M
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Now lets put all of this in a table to convince ourselves of what we have done:
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$ Million Year 0 Year 1

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Unlevered value
FCF -50.000 80.000
Vu @ ru=6% 75.472 0.000
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Interest tax shield

Debt capacity 38.023 0.000
Interest 0.000 1.521
Interest tax shield 0.000 0.608
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T = PV(ITS) @ ru=6% 0.574 0.000

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APV 76.046 0.000

NPV 26.046

D/V 50.0%

Note: the two numbers in bold are the key numbers we calculated using our system of
equations!

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 COMM370 Ting Xu

Question 4. Cirrusex, a large producer of tires, is considering building a small factory to

produce winter tires which requires an initial investment of $100M and is expected to
produce $50M in each of the next three years (years 1, 2, and 3). After the third year, the
factory will be abandoned with no salvage value. Cirrusex continuously rebalances its
capital structure to maintain a target D/E = 2/3. Cirrusexs corporate tax rate is 40%. Its
cost of debt is 5% and its cost of equity is 10%.

Calculate the projects value and NPV using the WACC method. Explain how Cirrusex
will rebalance its capital structure and calculate the projects annual debt capacity.

Solution (see also my spreadsheet)

rWACC = (2/5) x 5% x (1-.40) + (3/5) x 10% = 7.2%

Project value = $50M (1/.072) [1 1/1.0723] = $130.738M

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NPV = $130.738M - $100M = $30.738M

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Rebalancing and debt capacity:

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$ 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
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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
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Equity w/ D/V=2/5 78.443 54.091 27.985 0.000

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NPV 30.738
Net equity issuance 47.705 -24.352 -26.105 -27.985
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Question 5. Suppose a project will be financed in part with debt and that this debt has a
fixed schedule. What is the right discount rate to discount the interest tax shields generated
by such debt financing?
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Solution. In this case the risk of the tax shields will be roughly the same as the risk of debt,
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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.

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 COMM370 Ting Xu

Question 6. Peatco, a major oil refiner, is planning to build a new refinery which will cost
$15M up front and generate $2M in perpetual free cash flow starting in one year. Its
unlevered cost of capital is 15%. Peatco can borrow $10M for 12 years at an annual interest
rate of 10%. The loan contract specifies annual interest payments for 12 years and full
repayment of capital in year 12. Note that debt has a fixed schedule and that the firm will
not rebalance its capital structure. Peatco faces a 40% tax rate.

a) What is the all-equity value of the project? Should Peatco do the project if it is going to
be all-equity financed?

b) What is the value of the projects financing?

c) Should Peatco do the project if it is going to be financed with the 12-year loan?

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Solution

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

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The project is negative NPV if all-equity financed; so dont do it!

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b) Debt has a fixed schedule and so the right discount rate for interest tax shields is the cost
of debt (10%).
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Annual interest tax shield = .1 x $10M x .40 = $0.4M

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PVF = $0.4M x (1/.1) x (1-1/1.112) = $2.725M

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c) NPV = PVU + PVF = -$15M + $13.333M + $2.725M = $1.058M

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NPV with debt financing is positive, so you should take the project.
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Question 7. Refinex, a major oil refiner, is planning to build a new refinery which will cost
$15M up front and generate $25M in incremental sales for 5 years (years 1-5). The cost of
the goods sold is 60% of sales, operating expenses are $2M in each year of operation,
depreciation is $3M in each year of operation, there are no required changes in net working
capital, and the firm faces a 40% tax rate. Refinexs unlevered cost of capital is 10%.
Refinex can borrow $10M for 5 years at an annual interest rate of 5%. The loan contract
specifies annual interest payments for five years and full repayment of capital at the end of
year five.

a) What is the new refinerys free cash flow for years 0 to 5?

b) What is the all-equity value of the project? Should Refinex do the project if it is going to
be all-equity financed?

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c) What is the value of the projects financing?

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d) Should Refinex do the project if it is going to be financed with the 5-year loan?

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e) Do you think valuing the project using WACC would be easier than doing it using APV?

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Solution

a) Calculate the free cash flow:

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

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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
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Operating expenses 0.00 -2.00 -2.00 -2.00 -2.00 -2.00

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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
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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:

NPVU = -15M + 6M x (1/.1) x (1 1/1.15) = $7.74M

Yes, do it since NPV>0.

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 COMM370 Ting Xu

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 10.00 10.00 10.00 10.00 10.00 0.00
Interest 0.00 0.50 0.50 0.50 0.50 0.50
Interest tax shields (t=40%) 0.00 0.20 0.20 0.20 0.20 0.20
PVF 0.87

d) If the 5-year loan is taken, then

NPV = $7.74M + $0.87M = $8.61M

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Yes, we should take the loan because this adds value through tax shields and we should
take the project.

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e) No! The D/V is changing all the time and thus WACC is complicated. It is easier to use

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APV which works well with a fixed debt schedule!
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