The Link Between Capital Structure and Capital Budgeting

Fiera Corporation is evaluating a new project that costs $45,000. The project will be financed using 40% debt and 60% equity, thus maintaining the firm’s current debt-to-equity ratio. The firm’s stockholders have a required rate of return of 18.36%, and its bondholders expect a 10.68% rate of return. The project is expected to generate annual cash flows of $13,000 before taxes for the next two decades. Fiera Corporation is in the 36% tax bracket. Remember to show all your work.

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For this case you must:

1. Calculate the firm’s weighted average cost of capital (WACC).
2. Calculate the traditional net present value (NPV) of the project using the WACC. Explain if the project should be undertaken.
3. Use Modigliani and Miller’s Proposition II, and calculate the required return on unlevered equity.
4. Use the adjusted present value (APV) method to determine whether or not the project should be undertaken and explain why.
5. Use the flow-to-equity (FTE) method to determine whether or not the project should be undertaken and explain why.

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