Problem 2
HSBC Division is considering a new project costing $400 million. The project
cost can be depreciated on a straight-line over 20 years. Part of the cost of the
project will be nanced with a new bond issue. In order to nance a portion
of new project, HSBC Division has sold for $93:54 million a twenty year, zero
coupon bond with face value of $300 million. The issuance of debt will carry a
one time cost at year 0 of $12:9 million. The issuance cost can not be depreciated
or used to o¤set taxes. The project generates EBIT with an expected value of
$40 million for each of the next twenty years, commencing one year after the
start of the project. CFO believes that the debt obligation will be fullled with
probability ONE, implying that the interest expense deductions associated with
the tax-shield on the new debt have a zero covariance with the return on the
market. The cash ows of the project do vary with the market, with the implied
unlevered asset beta equal to 1:5. The expected return on the market is 12%
and the risk-free rate is 6%. The CFO believes that the government is likely
to push for an increase in the corporate income tax rate from 16% up to 28%,
and ascribes a 75% chance that government will succeed in getting to pass the
tax increase proposal. The CFO assumes that this event has zero covariance
with the market portfolios return and has no e¤ect on the projects unlevered
asset beta. He asks you to evaluate the project using APV. HSBC Division
must make its accept/reject decision on BEFORE outcome of the government
tax debate is known.
a) (5 points) What are the expected annual after-tax Unlevered Cash Flows
associated with the project?
b) (5 points) What is the discounted value (PV) of the after-tax Unlevered
Cash Flow stream?
c) (5 points) Compute an amortization table for the bond.
d) (5 points) What is the value of the Debt Tax Shield associated with this
project?
e) (2 point) What is the projects APV? Should HSBC Division invest into
project?
2