Problems-2-EMBADC 1 Stern School of Business – New York University FINC-GB.3231 – Valuation ______________________________________________________________________________ Problem Set #2: Estimating...

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Problems-2-EMBADC 1 Stern School of Business – New York University FINC-GB.3231 – Valuation ______________________________________________________________________________ Problem Set #2: Estimating the Discount Rate and Incorporating Leverage in DCF- Valuations Problem 1: DETERMINING THE CORRECT DISCOUNT RATE IN DCF-VALUATION FOR DU PONT Du Pont, a large chemical and paper conglomerate, is planning to sell its Paper division to American Chemical. Suppose you have been asked to identify the cost of capital of Du Pont after the sale of the division and collected the following firm and financial market information. You have established that all firms in the table pay corporate taxes at a 35% rate, and estimated a market risk premium of 6%. Du Pont’s target capital structure has 40% debt. American Chemical’s target capital structure for the division has 25% debt. Describe clearly how you would proceed in estimating the correct discount rate and also lay out any additional assumptions you would make. Problem 2: DETERMINING THE COST OF CAPITAL FOR STARBUCKS. Consider the following information for Starbucks, downloaded from Capital IQ as of December 2019. If the market value of Starbucks’ debt approximately equals the book value, the 10-year US T-bond rate equals 1.90%, the implied market risk premium is 6%, Starbucks’ marginal corporate tax rate is 21%, and the yield spread on BBB+ rated corporate bonds is 1.80%, how would you use this information to determine Starbucks’ current cost of capital or WACC? And what is your estimate of Starbuck’s business risk or asset beta, and its unlevered cost of capital? Motivate your approach and show your calculations. 2 3 Problem 3: VALUATION AND COST OF CAPITAL IN AN INTERNATIONAL CONTEXT Vale, a Brazilian-based international mining and shipping conglomerate, is considering the acquisition of several copper mines in Indonesia. The firm is trading on the New York Stock Exchange and an equity analyst following the firm wants to value the copper mines in US dollars. The projected free cash flows for the next 5 years (including a terminal value estimate) are summarized below (in $ millions): The analyst collected the following information in order to estimate the cost of capital for the acquisition: The analyst furthermore determined that the proportion of revenues that the mines generate from Indonesia equals 40%, whereas the average Indonesian company generates 60% of its revenues from the country. Vale currently has no operations in Indonesia. The marginal corporate tax rate for the mining operations equals 30%, and the target debt ratio for the acquisition equals 20%. The corresponding bond rating for the debt would be A3. With this information, please answer the following questions: (i) Calculate the dollar-based cost of capital for the acquisition based on information for the US only (that is, without the inclusion of a country risk premium). (ii) Suppose the analyst wants to include a country risk premium for Indonesia in the cost of equity estimate, which reflects the exposure (lambda) of the mines to the Indonesian economy and furthermore wants to include a sovereign spread for Indonesia in the cost of debt. What is the dollar-based cost of capital for the acquisition taking this country risk into account? (iii) If we assume that the cash flows from the mines would predominantly depend on global economic conditions, and that there is a 2.5% probability that the mines will be fully expropriated by the Indonesian government shortly after the end of year 4, how should the analyst proceed in valuing the mining operations, and what is the resulting value of the mines based on this new information? Motivate your approach and show your calculations. 4 Problem 4: DETERMINING THE APV FOR AN INVESTMENT PROJECT Consider a firm which is evaluating a project to produce solar water heaters. The project requires a $10 million investment and generates after-tax free cash flows of $1.75 million per year for 10 years. The opportunity cost of capital which reflects the project’s business risk equals 12%. With this information answer the following two questions. (i) Suppose the project is financed with $5 million debt and $5 million equity. The debt is provided as a term loan, which will be repaid in equal installments over the next 10 years. The interest rate on the debt equals 8% and the marginal corporate tax rate is 35%. Should the firm undertake the investment project? Motivate your answer and show all your calculations. (ii) Suppose you learn that the firm incurs issue costs (in the form of underwriting fees) of $400,000 to raise the $5 million in equity for the project. How would this information affect your project recommendation? Explain your answer. Problem 5: THE COST OF CAPITAL FOR THE HOME DEPOT FOR THE APV, WACC AND FTE- APPROACH Revisit the cost of capital calculation for the Home Depot example on p. 71 of the handout Estimating the Discount Rate in the DCF-Framework. Based on this information, answer the following two questions (note: you may find a small difference due to rounding). (i) Verify that the WACC calculated for the Home Depot equals 9.3% if we use the bottom- up approach to estimate the firm’s equity beta and assuming that the firm maintains a constant debt ratio in market value terms. (ii) Determine the discount rate you would use for an APV-valuation of the firm and also the discount rate you would use for a valuation based on the Flow to Equity approach.