1. Midwest American Airlines is a domestic airline specializing in short and mid-length flights in the U.S. Midwest. It is considering an expansion to serve some major cities in central Canada. Because these new routes would represent an international expansion, management views them as slightly riskier than the company’s traditional lines of business.
Midwest is currently funded with $120 million in debt. There are 5 million shares of common stock outstanding, and the stock price is $10 per share. Assume that the CAPM is true; the risk-free rate is 4%, and the risk premium on the market is 7%. Midwest’s stock has a beta of 1.4. The pre-tax expected return on the firm’s debt is 8%. The firm’s marginal tax rate is 34%.
a.) What is the WACC for the firm?
b.) Because of its risk, management would require the international expansion project to earn a return equal to the WACC plus a country-risk premium of 1.5%. What is the appropriate discount rate for this project?
2. Emerson Enterprises is deciding whether to expand its production facilities. Management has projected the following cash flows for the first two years (dollars in millions):
Year 1 Year 2
Revenues 125 160
Operating expenses (excluding depreciation) 40 60
Depreciation 25 36
Change in working capital 5 -8
Capital expenditures 30 40
The corporate marginal tax rate is 35%.
a. What is the EBIAT for this project for years one and two? What are the free cash flows for this project for the first two years?
b.. Assume that the project requires capital expenditures of $400M today (year 0), and that the depreciation figures above already incorporate that assumption. Also assume after year 2 (into perpetuity), this project’s FCFs will grow at a 2.5% rate. If a 12.5% cost of capital is appropriate for this project, estimate the value this project will add to Emerson.
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