Working Capital and Liquidity — MCQs

Calder Industries manufactures industrial equipment and is considering a project in a business segment with operating risk different from that of Calder's existing assets. The corporate finance team is reviewing the appropriate discount rate, the treatment of a foreseeable environmental cost, and a proposed separation of a noncore subsidiary. Exhibit 1 presents Calder's current financing and capital-market inputs. Calder's debt is publicly traded and has no material embedded options. The company can use interest tax deductions as incurred, and the stated pre-tax debt cost reflects the current marginal borrowing rate. An analyst initially proposes weighting debt and equity using their balance-sheet carrying amounts because those values are audited. The chief financial officer instead instructs the analyst to use current market values when estimating the opportunity cost of capital. The proposed project has risk comparable to a publicly traded pure-play company. After removing that company's financial leverage, the analyst estimates the unlevered beta shown in Exhibit 2. Calder intends to finance the project at the target debt-to-equity ratio stated in the exhibit. The target ratio is expected to remain stable, and debt beta is assumed to be zero. The analyst will use the relevered project beta with the risk-free rate and equity risk premium from Exhibit 1 to estimate a project-specific cost of equity. The project would also generate greenhouse-gas emissions. Calder's base-case operating forecast currently excludes carbon payments because the relevant legislation has not been enacted. Nevertheless, the investment team expects a carbon-pricing system to apply throughout the project's operating life and considers the expected price and emissions volume sufficiently reliable for inclusion in expected cash flows. Any carbon payments would be deductible for corporate income tax purposes. The team wishes to avoid both ignoring a material expected cost and double-counting the cost through simultaneous cash-flow and discount-rate adjustments. Separately, Calder's board proposes separating a mature subsidiary whose customers and capital needs differ from those of the parent. Under the proposal described in Exhibit 2, Calder would not sell shares to outside investors and would not receive cash. After the transaction, the subsidiary would be an independently traded company, and Calder's existing shareholders would directly own its shares in proportion to their current Calder holdings. Each analysis uses the tax rate stated in Exhibit 1. The beta calculation, environmental cash-flow adjustment, and restructuring classification are independently determinable and do not depend on the calculated corporate WACC.