Chapter 18

Capital Budgeting and Valuation with Leverage
18-1. Explain whether each of the following projects is likely to have risk similar to the average risk of the firm. a. The Clorox Company considers launching a new version of Armor All designed to clean and protect notebook computers.

b. Google, Inc., plans to purchase real estate to expand its headquarters. c. Target Corporation decides to expand the number of stores it has in the southeastern United States. While there may be some differences, the market risk of the cash flows from this new product is likely to be similar to Clorox’s other household products. Therefore, it is reasonable to assume it has the same risk as the average risk of the firm. A real estate investment likely has very different market risk than Google’s other investments in Internet search technology and advertising. It would not be appropriate to assume this investment as risk equal to the average risk of the firm. An expansion in the same line of business is likely to have risk equal to the average risk of the business. The theme park will likely be sensitive to the growth of the Chinese economy. Its market risk may be very different from GE’s other division, and from the company as a whole. It would not be appropriate to assume this investment as risk equal to the average risk of the firm.

d. GE decides to open a new Universal Studios theme park in China. a.

b.

c. d.

18-2.

Suppose Caterpillar, Inc., has 665 million shares outstanding with a share price of $74.77, and $25 billion in debt. If in three years, Caterpillar has 700 million shares outstanding trading for $83 per share, how much debt will Caterpillar have if it maintains a constant debt-equity ratio? E = 665 million × $74.77 = $49.7 billion, D = $25 billion, D/E = 25/49.722 = 0.503. E = 700 million × $83.00 = $58.1 billion. Constant D/E implies D = 58.1