Problem: Valuation and capital budgeting for a project
I've been trying to understand this problem, but it is very unclear to me how I'm suppose to go about it. It is quite a bit of text here, and hopefully that won't discourage anyone from lending a helping hand.
Ciao Inc. wants to raise $26 million in equity for a new project. In addition Ciao is planning to undertake $20 million in debt. The investment bank charges a 5% fee for issuing equity. No fee applies to debt issuance. The required interest rate on debt is 4%. The expected return on levered equity is 15% Ciao plans to keep a constant debt-to-equity ratio equal to 64.52%. The perpetual EBIT of the project is $7 million a year and there is no asset depreciation. The corporate tax rate is 25%.
So a quick recap if anyone wants to try in Excel.
Raise equity 26 000 000
Raise debt 20 000 000
Investment bank equity fee 5 %
Investment bank debt fee 0
Rs 15 %
debt-to-equity ratio 64.52 %
tc 25 %
Rb 4 %
Perpetual EBIT 7 000 000
Firstly, it never states what the initial outlay of the project is. It says the company wants to raise 26 million in equity and 20 in debt, so I take it that the cost of the project is 46 initially. However, it further states that the debt to eqity ratio should be 64.52 %, which means they 1) does not use all the debt from the issue or 2) that they use internal financing to make the chunk of equity bigger.
If we assume that they use both the equity and debt issuance + extra internal financing to get to a debt-to-equity of 64.52 %, then their proportions would be as follows:
Total debt (64,52 % = B/E) 20 000 000
Equity (absolute) 30 998 140
Implying that the initial investment for the project is the sum of the two.
Now, to calculate the tax adjusted WACC we find the following
Debt-to-value ratio 39.22 %
WACC = 10.29 %
Now I can calculate present value of the project and what not, but the problem is that I always come out with the wrong answer. The correct answer should be: 3.63 million.
The bankers' fee for issuing the equity: I assume that it should be subtracted at the beginning of the project and hence it represents an initial cost. In other words, not to be spread out throughout the lifetime of the project.
So basically what I have done is as follows:
EBIT*(1-25 %)/WACC = 51 000 850
Bankers' fee = 26 000 000 * 5 % = (1 300 000)
Initial outlay (debt+equity) = (50 998 140)
Now, this is far from the correct answer which is 3.63 million, so where am I wrong, please?
