CORPORATE FINANCE (28C00100)

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1 IMPORTANT The submitted exercise answers will be accepted only for those students that have successfully registered for the course lectures. (Please check the list on the course website to make sure your name is in the list of registered students before doing the assignment). LOGISTICS: The report of the answers answers must be placed in the Corporate Finance box on the second floor of Chydenia by 11:00 a.m. sharp or on instructor s desk before the lecture on the exercise due date indicated above. Please make sure that Aliases, Names and Student Numbers of all the group members are included on the report that is submitted. STUDENT HONOR CODE: Collaboration between groups is prohibited; this means that all work must be done within your own groups. Remember, three members are the maximum group size. FORMATTING: For all qualitative questions, the absolute maximum length for an answer is 1 page (font 12, 1.5 lines spaced) for each problem. Use a.22-caliber rifle instead of a 10 gauge shotgun in your answers: be brief and to the point. In numerical problems, you must also show all relevant work, not just the final answers. The questions require you to think rather than copy text from the course material. The answers may be handwritten, but a computer printout is encouraged. Poor appearance will make your report difficult to understand and grade. Please highlight your final answer when possible. PROBLEM 1 1p True or False? Briefly explain. a) Modigliani and Miller totally ignore the fact that as you borrow more you have to pay higher rates of interest. b) A firm s stockholders would never want the firm to invest in a negative NPV project. 1

2 PROBLEM 2 1p Consider a firm that consists of a machine that will produce cash flows of if the economy is good and 8000 if the economy is bad. The good and the bad states occur with equal probability. Initially, the firm has 1000 shares. It also has an outstanding debt with a face value (the amount to be paid) of 6000 due at the end of the period. There are no taxes or other market imperfections and the risk-free rate of interest is zero. a) What are the market values of equity and debt of the firm based on these cash flow expectations? b) Suppose that the firm announces that it will issue additional debt with a face value of 4000 that will be junior with respect to the existing debt, i.e., the new debt will be paid only after the first one is fully paid. The firm will use the entire proceeds to buy back shares. What are the new market values of the securities? c) How many shares will be outstanding as a result of this transaction? d) Does MM proposition I hold? PROBLEM 3 Wonderland Co. is financed entirely by common stock. The stock has a beta of 0.9 and is priced to offer a 9% expected return. Wonderland Co. now decides to repurchase half the common stock and substitute an equal value of debt. Assume that there are no taxes, and debt yields a risk-free 4% return. Assume also that the operating profit of the firm is expected to remain constant in perpetuity. Calculate: a) The beta of common stock after refinancing b) The required return on the stock after refinancing c) The change in expected earnings per share d) The change in price-earnings ratio PROBLEM 4 Aspen Inc. is a manufacturing firm that expects its EBIT to be 750,000 every year into perpetuity. Aspen has a cost of equity of 6% and 2 million shares outstanding. The firm currently has no debt, but it can borrow at 3%. Assume that M&M propositions I and II hold and that no costs of financial distress exist. The corporate tax rate is 20%. e) What is the share price of the firm? f) How will the value of the firm change if Aspen borrows 1 million and uses the funds to buy back shares? g) What is its WACC after the restructuring? h) Assume that the repurchase is announced to the public before it is completed, and that everyone has the same information as Aspen s executives do. What will the new share price be? 2

3 PROBLEM 5 Gizmo Oy has an EBIT of 250,000 which it expects to remain constant into perpetuity. The firm faces a 20% marginal corporate tax rate. It is able to borrow at an interest rate of 5% whereas its cost of equity capital in the absence of borrowing is 10%. Assume that MM propositions I and II hold. a) If there are no personal taxes, what is the value of the company when it has: i. No leverage? ii. 500,000 of debt? iii. 1 million of debt? b) Now assume the Finnish Parliament passes new legislation which introduces personal taxes as follows: The marginal personal tax rate on common stock income (capital gains and dividends) is 15% while the marginal personal tax rate on interest income is 40%. Determine the value of the company using each of the three debt alternatives in part (a). Hint: Merton Miller shows that the gain from tax shield (G) when personal taxes and corporate taxes are taken into account is: Ø ( 1-TpE )( 1-T G = DŒ1 - Œº 1-Tp c ) ø œ œß c) Why do the answers in parts (a) and (b) differ? PROBLEM 6 The Radical Investment Specialists Corporation (RISC) asked the Frankfurt Insurance Company, which specializes in bankruptcy insurance, to underwrite its risk of failure. The insurance company undertook an obligation to pay a required constant sum to the firm s creditors in the years in which losses are sustained, for an annual premium on this sum. This excess premium required to induce the insurance company to underwrite the risk varies as a function of the rate of the debt in the capital structure as set out in the table below. 3

4 Annual extra premium Debt/Assets (% of 10 million) 0% 0.05% 10% 0.20% 20% 0.25% 30% 0.35% 40% 0.50% 50% 0.70% 60% 1.00% 70% 1.45% 80% 2.00% 90% 2.70% RISC had five alternatives for financing its initial required investment of 10 million: 1. No debt and 10 million shares at 1 per share 2. 2 million debt and 8 million shares 3. 4 million debt and 6 million shares 4. 6 million debt and 4 million shares 5. 8 million debt and 2 million shares As the firm increases the proportion of debt, the number of shares issued decreases proportionally. However, the value of the firm increases by the formula: Value of firm (VL) = value if all-equity-financed (VU) + Tc D Thus, with leverage the firm obtains more than the required 10 million. Assume that excess assets are distributed as a cash dividend. Assume also that the corporate tax rate is 20% and that the discount rate (for present value calculations) is 6.7%. a) Plot the present value of the insurance premium offered to RISC as a function of the debt/assets ratio. b) Calculate for each alternative the net value of the firm, before the cash dividend is paid, with bankruptcy risk eliminated, i.e. VL = VU + Tc D PV (Premium). c) Find the optimal financial policy for RISC. d) Plot the value and net value of the firm as a function of its leverage ratio. 4

5 PROBLEM 7 Consider a project to produce solar water heaters. It requires a $10 million investment and offers a level after-tax cash flow of 1.75 million per year for 10 years. The opportunity cost of capital is 12%, which reflects the project s business risk. a) Suppose the project is financed with $5 million of debt and $5 million of equity. The interest rate for the debt is 8% and the marginal tax rate is 20%. The debt will be paid off in equal annual installments over the project s 10-year life. Calculate the adjusted present value (APV). b) How does APV change if the firm incurs issue costs of $400,000 to raise the $5 million of required equity? 5

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