Solution of the Menko case (finance)

Essay by nzuhairUniversity, Master'sA+, August 2004

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The Zambian proposal is prima facie tempting. But in order to accurately evaluate its contribution to the wealth of Menko's shareholders, it should be analyzed more in-depth. We will do this using the Adjusted Present Value approach.

The Adjusted Present Value (APV), as developed by Myers , defines the value of a levered firm as the value of an otherwise identical but unlevered firm plus the value of any "side effects" due to leverage. These side effects often include the tax shield of debt, expected bankruptcy costs, and agency costs. In symbols, APV is calculated as:

Where NPV is the value of an all-equity firm (base-case), calculated using the cash flows to unlevered equity and the unlevered cost of equity, and NPFV is the NPV of the effects of financing such as the tax shield benefits of debt (i.e. corporate tax rate (T) multiplied by the debt (D)). Hereinafter, we will first calculate the base-case NPV of the proposal, and then will calculate the tax shield benefits/losses that the proposed borrowing would entail, and will accordingly decide whether or not the proposal is beneficial to Menko.

Future Exchange Rates:

Before we proceed to our APV calculations, and given that the projected cash flow of the proposed facility is in Zambian dollars, and the proposed loan is in Yens, it is crucial for us - as consultants to the US parent company - to forecast future exchange rates in order to calculate the dollar value of the projection, and to adequately derive the proposal's profitability.

1. $US to $Zam:

We are asked to use the PPP method to forecast future Zam$/US$ exchange rates over the next 5 years. PPP is a theory which states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing...