Answer to Question #305069 in Finance for hassaan

Question

Essex Cosmetic Corp. has marginal tax rate of 40%. Table 2 gives the details of the balance sheet. The stock of Essex Cosmetic Corp. has a market-to-book ratio of 2. The firm’s bonds have a face value of £150 million and sell at a price of 120% of face value. The cost of equity is 12%, pretax cost of debt is 7%.

 Essex Cosmetic Corp. (Book values, £ million) 

                     Asset Value      £330. Debt    £ 150

Equity £ 180

                                              £330            £ 330

a.    Essex Cosmetic Corp wants to invest in machine with cash flows of £ 5 million per year pretax and it continues indefinitely. What is value of machine, given initial investment of £20 million. The machine cost of £20 million will be financed with £10 million in new debt initially. Compute the value of the machine using the APV method, assuming Essex Cosmetic Corp. will maintain a constant debt-equity ratio for this investment. 

Answer 1

Marginal tax rate =40%

market to book ratio =2

face value of bonds =150 million euros

selling price = 120% of face value.

the cost of equity =12%

pretax cost of debt =7%

asset value =330 million euros

equity =180 million euros

debt =150 million euros

machine cashflows per year pretax = 5 million

initial investment =20 million euros

debt = 10 million euros

Adjusted Present Value (APV)= PV of unlevered firm+ PV of financing effects

PV of unlevered firm = 100%equity -financed = 180 million euros

PV of financing effects = interest tax shield=interest expense *tax rate

interest tax shield = 5million euros *40%=0.2 million euros

PV of unlevered firm = (180+0.2) million euros

=180.2million euros