Question

Kendall Square Associates (KSA), is a partnership set up to develop a condo in Cambridge. Its only asset is a condo project to be completed next year, which will yield a net cash flow of $80 millon (in year 1). KSA faces a corporate tax rate of 25% and its asset has an expected rate of return (cost of capital) of 15% by the market. KSA pays out all its earnings to shareholders as dividends. Assume shareholders pay no taxes on dividends.______________________________________________________________________

(a) Suppose KSA is 100% equity financed.
(i ) What is the after-tax cash flow for KSA in year 1?
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(ii) What is the current market value of KSA?
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(b) Suppose KSA is financed by both debt and equity. KSA has an outstanding loan of $40 million, which carries an interest rate of 5%.
(i ) What is the total after-tax cash flow for KSA in year 1?
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(ii ) What is the current market value of KSA in this case?
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(iii ) What is the current market value of KSA’s debt?
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(iv) What is the current market value of KSA’s equity in this case?
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(v) What is KSA’s debt-to-equity ratio?

Answer 1

When KSA is 100% equity financed, the after-tax cash flow in year 1 is $60 million. The current market value of KSA in this case is $400 million.

Step-by-step explanation:

To calculate the after-tax cash flow for KSA in year 1 when it is 100% equity financed, we need to consider the corporate tax rate. The after-tax cash flow can be calculated as the net cash flow multiplied by (1 - tax rate). In this case, the after-tax cash flow would be $80 million x (1 - 0.25) = $60 million.

To calculate the current market value of KSA when it is 100% equity financed, we can use the formula: Market value = After-tax cash flow / Expected rate of return. In this case, the market value would be $60 million / 0.15 = $400 million.

If KSA is financed by both debt and equity and has an outstanding loan of $40 million, the total after-tax cash flow in year 1 would be the sum of the net cash flow and the interest savings from the loan. In this case, it would be $80 million + ($40 million x 0.05) = $82 million.