Use the following information to answer the question(s)below.
Taggart Transcontinental is considering a $250 million investment to launch a new rail line.The project is expected to generate a free cash flow of $32 million per year,and its unlevered cost of capital is 8%.Taggart's corporate tax rate is 21%.Taggert has 4 million shares of stock outstanding.
-Assuming that to fund the investment Taggart will take on $250 million in permanent debt and assuming Taggart will incur a 2% (after-tax)underwriting fee on the new debt issue,the NPV of Taggart's new rail line is closest to:
A)$198 million.
B)$210 million.
C)$235 million.
D)$240 million.

Question

Quizplus · Accepted Answer

To calculate the NPV of the new rail line, we need to discount the free cash flows generated by the project using the unlevered cost of capital, which is 8%.

PV of Free Cash Flows = FCF / (1 + WACC)^n

where FCF = $32 million, WACC = 8%, and n ranges from 1 to infinity.

The formula for the present value of a growing perpetuity is:

PV = CF / (WACC - g)

where CF = $32 million, WACC = 8%, and g = 2% (g represents the annual growth rate of free cash flows).
Substituting the values, we get:

PV = $32 million / (0.08 - 0.02) = $400 million

Now, we need to calculate the present value of the interest tax shield (ITS) associated with the $250 million debt. The ITS represents the tax savings resulting from the interest payments on the debt.

PV of ITS = (1 - tax rate) x interest expense x (1 - PV of the underwriting fee)

where tax rate = 21%, interest expense = $250 million x 8% = $20 million, and PV of the underwriting fee = 0.98 (after factoring in the 2% after-tax underwriting fee)

Substituting the values, we get:

PV of ITS = (1 - 0.21) x $20 million x (1 - 0.98) = $0.314 million

Finally, we need to subtract the cost of the investment ($250 million) to arrive at the NPV of the project.

NPV = PV of FCF + PV of ITS - Cost of Investment

NPV = $400 million + $0.314 million - $250 million

NPV = $150.314 million

Therefore, the closest answer is C) $235 million.

Use the Following Information to Answer the Question(s)below