Question 6 – APV (10 marks] Joe Exotic Inc. is considering expanding into the cruise line business. To finance the expansion project, Joe Exotic will issue a 3-year, zero coupon bond with face value of $500 million for $450.97 million. Joe’s consultants have analyzed the cruise line market and produced the following scenarios for the expansion project for each of the next three years: Scenario Probability | EBIT Deprecation CapEx High 0.35 750 Medium |
0.35 500 Low 0.30 50 50 50 50 Joe’s consultants have determined that the unlevered cost of capital in the cruise line industry is 6%. The expected return on the market portfolio is 4.75% and the risk-free rate is 1.50%. Joe Exotic Inc. has a D/E ratio of 0.75 and is subject to a 35% corporate tax. (Note: When EBIT is less than debt interest, a firm is unable to get a tax deduction.) a) Use the APV approach to evaluate Joe’s expansion project. Should Joe Exotic invest into the cruise line business if the initial cost is $800 million? b) List three scenarios in which you would prefer to use the APV approach over the WACC approach. Note: Show your work in detail.
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