DUKE UNIVERSITY Fuqua School of Business. FINANCE CORPORATE FINANCE Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2.

Size: px
Start display at page:

Download "DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2."

Transcription

1 DUK UNIRSITY Fuqua School of Business FINANC CORPORAT FINANC Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Suppose the corporate tax rate is 40%. Consider a firm that earns $1,000 before interest and taxes each year (in perpetuity) with no risk. The firm s capital expenditures equal its depreciation expenses each year, and it will have no changes to its net working capital. The riskfree interest rate is 5%. (a) Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the firm s equity? (b) Suppose instead the firm makes interest payments of $500 per year. What is the value of equity? What is the value of debt? (c) What is the difference between the total value of the firm with leverage and without leverage? (d) The difference in part (c) is equal to what percentage of the value of the debt? 2. Western Lumber Company expects to have a free cash flow of $4.25 million in the coming year. Free cash flows are expected to grow at a rate of 4% per year thereafter. Western Lumber has an equity cost of capital of 10% and a debt cost of capital of 6%. The corporate tax rate is 35%. If Western Lumber maintains a (constantly rebalanced) debt-equity ratio of 0.50, what is the present value of its interest tax shield? 3. Suppose that the Drazil Susej Corporation (DSC) has an equity cost of capital of 8.5%, a debt cost of capital of 7%, a marginal corporate tax rate of 35%, and a debt-equity ratio of 2.6. Suppose that Goodyear does not plan to rebalance its debt, i.e., its current debt is perpetual. (a) What is DSC s WACC? (b) What is DSC s unlevered cost of capital? 4. Kurz Manufacturing is currently an all-equity firm with 20 million shares outstanding and stock price of $7.50 per share. Although investors currently expect Kurz to remain an allequity firm, Kurz plans to announce that it will borrow $50 million and use the funds to repurchase shares (i.e., Kurz s announcement is not anticipated by investors and thus not reflected in the current stock price). Kurz will pay interest only on this debt, and it has no further plans to increase or decrease the amount of debt. Kurz is subject to a 40% corporate tax rate. (a) What is the market value of Kurz s existing assets before the announcement? 1

2 (b) What is the market value of Kurz s assets (including any tax shields) just after the debt is issued, but before the shares are repurchased? (c) What is Kurz s share price just before the share repurchase? How many shares will Kurz repurchase? (d) What are Kurz s market value balance sheet and share price after the share repurchase? 5. Merck s simplified balance sheets (using book and market values) are currently as follows: Balance Sheet (book values in millions) Net working capital 1,473 Long-term debt 5,269 Long-term assets 14,935 quity 11,139 Total assets 16,408 Total liabilities 16,408 Balance Sheet (market values in millions) Net working capital 1,473 Long-term debt 5,269 Market value of long-term assets 51,212 quity 47,416 Total assets 52,685 Total liabilities 52,685 Suppose that Merck decides to move to a 50% book debt-to-value ratio by issuing debt and using the proceeds to repurchase shares. The corporate tax rate is 40%; consider only corporate taxes. Now construct Merck s balance sheet (with market values only) to reflect the new capital structure, making sure to add an item called P(additional tax shields) on the asset side of the balance sheet. Before it changes its capital structure, Merck has 1,248 million shares outstanding. What is the stock price before and after the change? 6. Hula nterprises is considering a new project to produce solar water heaters. The finance manager wishes to find an appropriate risk adjusted discount rate for the project. The(equity) beta of Hot Water, a firm currently producing solar water heaters, is 1.3. Hot Water has a debt to total value ratio of 0.4. The expected return on the market is 14% and the risk-free rate is 8%. Throughout this problem, assume that the debt is risk-free and that it is constant (i.e., the debt is never rebalanced). (a) Suppose the corporate tax rate is 30%. What is the asset (or unlevered) beta for the solar water heater project? (b) If Hula is an equity financed firm, what is the weighted average cost of capital for the project? (c) If Hula has a debt to equity ratio of 2, what is the weighted average cost of capital for the project? (d) Hula s chairman wishes to know why the cost of capital for Hot Water cannot be used directly. xplain why. (e) The finance manager believes that the solar water heater project can only support 30 cents of debt for every dollar of asset value, i.e., the debt capacity is 30 cents for every dollar of asset value. This is lower than the cents to every dollar of asset value (debt to equity ratio of 2) that current projects can support. Current projects have higher collateral value than the assets of the new solar heater project. Hence she 2

3 is not sure that the debt to equity ratio of 2 used in the weighted average cost of capital calculation is valid. What is the appropriate capital structure to use? What is the weighted average cost of capital that you will arrive at with this capital structure? 7. Company XYZ is currently financed with 40% debt (a 40% debt-to-value ratio). The average current yield on government securities is 10%. The expected return on the S&P500 portfolio is 20%. The corporate tax rate is 20% and XYZ s stock has a beta of 1.6. XYZ can borrow at 200 basis points above the prevailing government rate. (a) What is XYZ s weighted average cost of capital under the current capital structure? (b) What is XYZ s cost of capital if it decides to pursueapolicy of always using 100% equity financing instead? (i) First, solve this under the assumption that XYZ s debt will never be rebalanced. (ii) Now, solve this under the assumption that XYZ s debt will be constantly rebalanced. 8. If it were unlevered, the overall firm beta for Wild Widgets Inc. (WWI) would be 0.9. WWI has a target debt/equity ratio of 1/2 and plans to constantly rebalance its debt in order to maintain it. The expected return on the market is 16%, and Treasury bills are currently selling to yield 8%. WWI one-year bonds(with a face value of $1,000) carry an annual coupon of 7% and are selling for $ The corporate tax rate is 34%. (a) What is WWI s cost of debt? (b) What is WWI s weighted average cost of capital? (c) What is WWI s cost of equity? 3

4 Solutions 1. Because the firm s cash flows are riskless, we have r = r D = 5%. (a) If the firm has no debt and pays out its net income (of $600 = $1,000(1 0.40)) as a dividend each year, the firm s equity is worth U = $ = $12,000. (b) If the firm makes (riskless) interest payments of $500 per year, then the equity-holders will receive an annual dividend of $300 = ($1,000 $500)(1 0.40). Their equity is then worth L = $ = $6,000. The bondholders receive $500 every year. Their debt is worth (c) The levered value of the firm is D L = $ = $10,000. L = L +D L = $6,000+$10,000 = $16,000. The difference between the levered value and the unlevered value is L U = $16,000 $12,000 = $4,000. (d) This difference is the present value of the interest tax shield, which is a fraction t c of the debt D L : P(interest tax shield) = t c D L = (0.40)($10,000) = $4, We can calculate the value of Western Lumber s interest tax shield by comparing its value with and without leverage. The expected return on Western Lumber s unlevered assets is given by r A = ( ) D r D + ( ) ( ) ( ) r = (0.06) + (0.10) = 8.67% If Western Lumber was all-equity financed, then its value would be U = $4.25M = $91.07M. To calculate Western Lumber s levered value, we first need to calculate its weighted-average cost of capital: WACC = D D + (1 t c)r D + D + r = (1 0.35)(0.06) + 1 (0.10) = 7.97%

5 The levered value of Western Lumber is therefore L = $4.25M = $107.14M. This levered value exceeds the unlevered value by the present value of the interest tax shield, that is, by P(interest tax shield) = L U = $107.14M $91.07M = $16.07M. 3. We have r = 8.5%, r D = 7%, t c = 0.35, and D/ = 2.6 (which corresponds to D/ = = 0.722). (a) DSC s weighted average cost of capital is WACC = D (1 t c)r D + r = (0.722)(1 0.35)(0.07) +(0.278)(0.085) = 5.65%. (b) We know that the weighted average cost of capital satisfies ( ) D WACC = 1 t c r A 5.65% = [ 1 (0.35)(0.722) ] r A. This implies that r A = 7.56%. 4. (a) Because Kurz Manufacturing is initially all-equity financed, its value is the value of its equity: U = U = 20 million $7.50 = $150 million. (b) Right after the debt is issued, Kurz s value increases by the amount of debt it raised ($50 million), and by the tax shield that this debt creates(0.40 $50 million = $20 million). That is, its value increases by $70 million. (c) Before the debt is repurchased, the total value of the firm is $150 million+$70 million = $220 million. Since the debt is worth $50 million (i.e., the debtholders get what they pay for), the equity must be worth $220 million $50 million = $170 million. This implies that Kurz s share price is $170 million 20 million = $8.50. This in turn implies that the $50 million raised through the debt issue will allow Kurz to buy back $50 million $8.50 = million shares. (d) After the share repurchase, the total market value of Kurz Manufacturing is $220 million $50 million = $170 million. On the asset side of the balance sheet, Kurz s unlevered assets are worth $150 million, as before, and the debt tax shield is $20 million. On the liability side of the balance sheet, the debt is worth $50 million, and the equity is worth $120 million (20 million million = million shares trading at $8.50 each). 5. The long-term debt is increased from $5,269 to 50% of book = 50% $16,408 = $8,204, 5

6 that is it is increased by $8,204 $5,269 = $2,935. This implies that the debt tax shield is increasedby0.40 $2,935 = $1,174, andthemarketvalueofthefirmisnow$52,685+$1,174 = $53,859. The new balance sheet (with market values) will look as follows: Balance Sheet (market values in millions) Net working capital 1,473 Long-term debt 8,204 Mkt value of long-term assets 51,212 quity 45,655 P(additional tax shields) 1,174 Total assets 53,859 Total liabilities 53,859 Before the change, the equity is worth $47,416, and 1,248 shares are outstanding, so that the stock price is P = 47,416 1,248 = Upon the firm s announcement of its plans to repurchase shares, the firm s value should go up by the extra debt tax shield that this will generate. That is, the equity goes up to $47,416+$1,174 = $48,590, and each share is then worth P = 48,590 1,248 = The amount raised from the new debt, $2,935, is therefore used to repurchase 2, = shares. 6. (a) When the tax rate is 30%, the asset beta (unlevered beta) of the solar heater project is β 1.3 β A = 1+(1 t c ) D = 1+(1 0.30) 2 = Notice that the debt-to-equity ratio is = 2 3 when the debt-to-value ratio is 0.4. (b) If Hula is an all-equity financed firm, the weighted average cost of capital for the project is just the unlevered cost of equity. The unlevered cost of equity is given by the CAPM: r A = r unlevered = r f +β A (r m r f ) = 0.08+(0.8863)( ) = 13.32%. (c) The levered beta corresponding to a debt-to-equity ratio of 2 is [ β levered = 1+(1 t c ) D ] β A = [1+(1 0.30)(2)](0.8863) = Hence the return on equity corresponding to the leverage of 2 is given by the CAPM: r levered = 0.08+(2.13)( ) = 20.8%. Thus the weighted average cost of capital for the project is ( ) D p ( ) WACC = (1 t c )r p p D + r p = 0.667(1 0.30)(0.08) (0.208) = 10.7%. 6

7 (d) Hot Water may have a different capital structure and thus its weighted average cost of capital is not applicable. ven though the business risk is the same, the difference in capital structure implies a different weighted average cost of capital. (e) You are explicitly told that the new project has a lower debt capacity. Thus it can only support 30 cents of debt for every dollar of asset value. xisting assets can support cents. Thus the long run debt capacity of the new project is different. Hence we need to account for this while doing our capital budgeting. The appropriate leverage adjustment is the debt to value ratio of 0.3. First, the levered beta corresponding to the debt to total value ratio of 0.3 is calculated as follows: β levered = [ 1+(1 t c ) D ] β A = [ 1+(1 0.30) The corresponding return on equity, as given by the CAPM, is r = ( ) = 14.9%, and the weighted average cost of capital is then ( ) D p ( ) WACC = (1 t c )r p p D + r p ] (0.8863) = = 0.3(1 0.30)(0.08) + 0.7(0.149) = 12.1%. Hence 12.1% rather than 10.7% is the right answer. 7. (a) With a debt-to-value ratio of 40%, we have D = 40% 60% compute the cost of equity: = 2/3. We use the CAPM to r = r f +β (r m r f ) = ( ) = 26%. Noticing that r D = 10%+2% = 12%, we have ( ) ( ) D WACC = (1 t c )r D + r = 0.40(1 0.20)(0.12) +0.60(0.26) = 19.44%. (b) The risk premium on XYZ s debt is 0.02 = β D ( ), for a β D of 0.2. (i) When the debt is permanent, we can unlever the equity beta to get an (unlevered) asset beta as follows: Using CAPM, we find β A = β + ( D ) (1 tc )β D 1+ ( D ) (1 tc ) = (1 0.20)(0.2) (1 0.20) = r A = r f +β A (r m r f ) = ( ) = 21.13%. 7

8 (ii) When the debt is constantly rebalanced, we can unlever the equity beta to get an (unlevered) asset beta as follows: ( ) ( ) D β A = β D + β = (0.40)(0.2) +(0.60)(1.6) = Using CAPM, we find r A = r f +β A (r m r f ) = ( ) = 20.40%. 8. From the data we have r m = 0.16, r f = 0.08, D/ = 1/3, and / = 2/3. Also the beta of an otherwise identical but unlevered firm is 0.9. This means that r A = r f +(r m r f )β A = 0.08+( )(0.9) = 15.2%. (a) WWI one-year coupon bonds have a face value of $1,000. One year from now, they will pay the face value and the 7% coupon, i.e. 1,000(1+0.07) = 1,070. Since WWI s bonds are now selling for $972.72, we can deduct the value for WWI s (pre-tax) cost of debt: r D = 1,070 1 = 10% (b) The weighted average cost of capital for a levered firm can be calculated as follows: WACC L = r A D t cr D = (0.34)(0.10) = %. 3 (c) Since WACC L = r D (1 t c ) D +r, we have = 0.10(1 0.34) 1 3 +r 2 3, which implies r = 17.80%. 8

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2.

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2. DUKE UNIVERSITY Fuqua School of Business FINANCE 351 - CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Suppose the corporate tax rate is 40%, and investors pay a tax

More information

Financial Markets and Valuation - Tutorial 6: SOLUTIONS. Capital Structure and Cost of Funds

Financial Markets and Valuation - Tutorial 6: SOLUTIONS. Capital Structure and Cost of Funds Financial Markets and Valuation - Tutorial 6: SOLUTIONS Capital Structure and Cost of Funds (*) denotes those problems to be covered in detail during the tutorial session (*) Problem 1. (Ross, Westerfield

More information

Chapter 14 Capital Structure in a Perfect Market

Chapter 14 Capital Structure in a Perfect Market Chapter 14 Capital Structure in a Perfect Market 14-1. Consider a project with free cash flows in one year of $130,000 or $180,000, with each outcome being equally likely. The initial investment required

More information

t = 1 2 3 1. Calculate the implied interest rates and graph the term structure of interest rates. t = 1 2 3 X t = 100 100 100 t = 1 2 3

t = 1 2 3 1. Calculate the implied interest rates and graph the term structure of interest rates. t = 1 2 3 X t = 100 100 100 t = 1 2 3 MØA 155 PROBLEM SET: Summarizing Exercise 1. Present Value [3] You are given the following prices P t today for receiving risk free payments t periods from now. t = 1 2 3 P t = 0.95 0.9 0.85 1. Calculate

More information

Cost of Capital and Project Valuation

Cost of Capital and Project Valuation Cost of Capital and Project Valuation 1 Background Firm organization There are four types: sole proprietorships partnerships limited liability companies corporations Each organizational form has different

More information

Test3. Pessimistic Most Likely Optimistic Total Revenues 30 50 65 Total Costs -25-20 -15

Test3. Pessimistic Most Likely Optimistic Total Revenues 30 50 65 Total Costs -25-20 -15 Test3 1. The market value of Charcoal Corporation's common stock is $20 million, and the market value of its riskfree debt is $5 million. The beta of the company's common stock is 1.25, and the market

More information

If you ignore taxes in this problem and there is no debt outstanding: EPS = EBIT/shares outstanding = $14,000/2,500 = $5.60

If you ignore taxes in this problem and there is no debt outstanding: EPS = EBIT/shares outstanding = $14,000/2,500 = $5.60 Problems Relating to Capital Structure and Leverage 1. EBIT and Leverage Money Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes [EBIT] are projected

More information

Leverage. FINANCE 350 Global Financial Management. Professor Alon Brav Fuqua School of Business Duke University. Overview

Leverage. FINANCE 350 Global Financial Management. Professor Alon Brav Fuqua School of Business Duke University. Overview Leverage FINANCE 35 Global Financial Management Professor Alon Brav Fuqua School of Business Duke University Overview Capital Structure does not matter! Modigliani & Miller propositions Implications for

More information

The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1

The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Chapter 17 Valuation and Capital Budgeting for the Levered Firm 17A-1 Appendix 17A The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Introduction A leveraged buyout (LBO) is the acquisition

More information

Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.)

Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.) Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.) The primary focus of the next two chapters will be to examine the debt/equity choice by firms. In particular,

More information

The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Introduction

The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Introduction Chapter 18 Valuation and Capital Budgeting for the Levered Firm 18A-1 Appendix 18A The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Introduction A leveraged buyout (LBO) is the acquisition

More information

SOLUTIONS. Practice questions. Multiple Choice

SOLUTIONS. Practice questions. Multiple Choice Practice questions Multiple Choice 1. XYZ has $25,000 of debt outstanding and a book value of equity of $25,000. The company has 10,000 shares outstanding and a stock price of $10. If the unlevered beta

More information

The Adjusted-Present-Value Approach to Valuing Leveraged Buyouts 1)

The Adjusted-Present-Value Approach to Valuing Leveraged Buyouts 1) IE Aufgabe 4 The Adjusted-Present-Value Approach to Valuing Leveraged Buyouts 1) Introduction A leveraged buyout (LBO) is the acquisition by a small group of equity investors of a public or private company

More information

Use the table for the questions 18 and 19 below.

Use the table for the questions 18 and 19 below. Use the table for the questions 18 and 19 below. The following table summarizes prices of various default-free zero-coupon bonds (expressed as a percentage of face value): Maturity (years) 1 3 4 5 Price

More information

] (3.3) ] (1 + r)t (3.4)

] (3.3) ] (1 + r)t (3.4) Present value = future value after t periods (3.1) (1 + r) t PV of perpetuity = C = cash payment (3.2) r interest rate Present value of t-year annuity = C [ 1 1 ] (3.3) r r(1 + r) t Future value of annuity

More information

CHAPTER 15 Capital Structure: Basic Concepts

CHAPTER 15 Capital Structure: Basic Concepts Multiple Choice Questions: CHAPTER 15 Capital Structure: Basic Concepts I. DEFINITIONS HOMEMADE LEVERAGE a 1. The use of personal borrowing to change the overall amount of financial leverage to which an

More information

GESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE

GESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE GESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE 1 ST SEMESTER 2010-2011 Chapter 18 Capital Budgeting and Valuation with Leverage

More information

Finance 2 for IBA (30J201) F. Feriozzi Re-sit exam June 18 th, 2012. Part One: Multiple-Choice Questions (45 points)

Finance 2 for IBA (30J201) F. Feriozzi Re-sit exam June 18 th, 2012. Part One: Multiple-Choice Questions (45 points) Finance 2 for IBA (30J201) F. Feriozzi Re-sit exam June 18 th, 2012 Part One: Multiple-Choice Questions (45 points) Question 1 Assume that capital markets are perfect. Which of the following statements

More information

Chapter 17 Does Debt Policy Matter?

Chapter 17 Does Debt Policy Matter? Chapter 17 Does Debt Policy Matter? Multiple Choice Questions 1. When a firm has no debt, then such a firm is known as: (I) an unlevered firm (II) a levered firm (III) an all-equity firm D) I and III only

More information

Corporate Finance, Fall 03 Exam #2 review questions (full solutions at end of document)

Corporate Finance, Fall 03 Exam #2 review questions (full solutions at end of document) Corporate Finance, Fall 03 Exam #2 review questions (full solutions at end of document) 1. Portfolio risk & return. Idaho Slopes (IS) and Dakota Steppes (DS) are both seasonal businesses. IS is a downhill

More information

BA 351 CORPORATE FINANCE. John R. Graham Adapted from S. Viswanathan LECTURE 10 THE ADJUSTED NET PRESENT VALUE METHOD

BA 351 CORPORATE FINANCE. John R. Graham Adapted from S. Viswanathan LECTURE 10 THE ADJUSTED NET PRESENT VALUE METHOD BA 351 CORPORATE FINANCE John R. Graham Adapted from S. Viswanathan LECTURE 10 THE ADJUSTED NET PRESENT VALUE METHOD FUQUA SCHOOL OF BUSINESS DUKE UNIVERSITY 1 THE ADJUSTED NET PRESENT VALUE METHOD COPING

More information

U + PV(Interest Tax Shield)

U + PV(Interest Tax Shield) CHAPTER 15 Debt and Taxes Chapter Synopsis 15.1 The Interest Tax Deduction A C-Corporation pays taxes on proits ater interest payments are deducted, but it pays dividends rom ater-tax net income. Thus,

More information

Corporate Finance: Final Exam

Corporate Finance: Final Exam Corporate Finance: Final Exam Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. 1. DayTop Inns is a publicly traded company, with 10 million shares

More information

The Assumptions and Math Behind WACC and APV Calculations

The Assumptions and Math Behind WACC and APV Calculations The Assumptions and Math Behind WACC and APV Calculations Richard Stanton U.C. Berkeley Mark S. Seasholes U.C. Berkeley This Version October 27, 2005 Abstract We outline the math and assumptions behind

More information

FINC 3630: Advanced Business Finance Additional Practice Problems

FINC 3630: Advanced Business Finance Additional Practice Problems FINC 3630: Advanced Business Finance Additional Practice Problems Accounting For Financial Management 1. Calculate free cash flow for Home Depot for the fiscal year-ended February 1, 2015 (the 2014 fiscal

More information

Practice Exam (Solutions)

Practice Exam (Solutions) Practice Exam (Solutions) June 6, 2008 Course: Finance for AEO Length: 2 hours Lecturer: Paul Sengmüller Students are expected to conduct themselves properly during examinations and to obey any instructions

More information

1 Pricing options using the Black Scholes formula

1 Pricing options using the Black Scholes formula Lecture 9 Pricing options using the Black Scholes formula Exercise. Consider month options with exercise prices of K = 45. The variance of the underlying security is σ 2 = 0.20. The risk free interest

More information

CHAPTER 8. Problems and Questions

CHAPTER 8. Problems and Questions CHAPTER 8 Problems and Questions 1. Plastico, a manufacturer of consumer plastic products, is evaluating its capital structure. The balance sheet of the company is as follows (in millions): Assets Liabilities

More information

Bonds, Preferred Stock, and Common Stock

Bonds, Preferred Stock, and Common Stock Bonds, Preferred Stock, and Common Stock I. Bonds 1. An investor has a required rate of return of 4% on a 1-year discount bond with a $100 face value. What is the most the investor would pay for 2. An

More information

NIKE Case Study Solutions

NIKE Case Study Solutions NIKE Case Study Solutions Professor Corwin This case study includes several problems related to the valuation of Nike. We will work through these problems throughout the course to demonstrate some of the

More information

Things to Absorb, Read, and Do

Things to Absorb, Read, and Do Things to Absorb, Read, and Do Things to absorb - Everything, plus remember some material from previous chapters. This chapter applies Chapter s 6, 7, and 12, Risk and Return concepts to the market value

More information

Chapter 7. . 1. component of the convertible can be estimated as 1100-796.15 = 303.85.

Chapter 7. . 1. component of the convertible can be estimated as 1100-796.15 = 303.85. Chapter 7 7-1 Income bonds do share some characteristics with preferred stock. The primary difference is that interest paid on income bonds is tax deductible while preferred dividends are not. Income bondholders

More information

Chapter 13, ROIC and WACC

Chapter 13, ROIC and WACC Chapter 13, ROIC and WACC Lakehead University Winter 2005 Role of the CFO The Chief Financial Officer (CFO) is involved in the following decisions: Management Decisions Financing Decisions Investment Decisions

More information

THE FINANCING DECISIONS BY FIRMS: IMPACT OF CAPITAL STRUCTURE CHOICE ON VALUE

THE FINANCING DECISIONS BY FIRMS: IMPACT OF CAPITAL STRUCTURE CHOICE ON VALUE IX. THE FINANCING DECISIONS BY FIRMS: IMPACT OF CAPITAL STRUCTURE CHOICE ON VALUE The capital structure of a firm is defined to be the menu of the firm's liabilities (i.e, the "right-hand side" of the

More information

Corporate Finance: Final Exam

Corporate Finance: Final Exam Corporate Finance: Final Exam Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. For partial credit, when discounting, please show the discount rate

More information

Leverage and Capital Structure

Leverage and Capital Structure Leverage and Capital Structure Ross Chapter 16 Spring 2005 10.1 Leverage Financial Leverage Financial leverage is the use of fixed financial costs to magnify the effect of changes in EBIT on EPS. Fixed

More information

Problem 1 Problem 2 Problem 3

Problem 1 Problem 2 Problem 3 Problem 1 (1) Book Value Debt/Equity Ratio = 2500/2500 = 100% Market Value of Equity = 50 million * $ 80 = $4,000 Market Value of Debt =.80 * 2500 = $2,000 Debt/Equity Ratio in market value terms = 2000/4000

More information

COST OF CAPITAL. Please note that in finance, we are concerned with MARKET VALUES (unlike accounting, which is concerned with book values).

COST OF CAPITAL. Please note that in finance, we are concerned with MARKET VALUES (unlike accounting, which is concerned with book values). COST OF CAPITAL Cost of capital calculations are a very important part of finance. To value a project, it is important to discount the cash flows using a discount rate that incorporates the debt-equity

More information

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #8 Prof. Simon Gervais Fall 2011 Term 2

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #8 Prof. Simon Gervais Fall 2011 Term 2 DUKE UNIVERSITY Fuqua School of Business FINANCE 351 - CORPORATE FINANCE Problem Set #8 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Hors d Age Cheeseworks has been paying a regular cash dividend

More information

ENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure

ENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure ENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure Chapter 9 Valuation Questions and Problems 1. You are considering purchasing shares of DeltaCad Inc. for $40/share. Your analysis of the company

More information

Corporate Finance & Options: MGT 891 Homework #6 Answers

Corporate Finance & Options: MGT 891 Homework #6 Answers Corporate Finance & Options: MGT 891 Homework #6 Answers Question 1 A. The APV rule states that the present value of the firm equals it all equity value plus the present value of the tax shield. In this

More information

The cost of capital. A reading prepared by Pamela Peterson Drake. 1. Introduction

The cost of capital. A reading prepared by Pamela Peterson Drake. 1. Introduction The cost of capital A reading prepared by Pamela Peterson Drake O U T L I N E 1. Introduction... 1 2. Determining the proportions of each source of capital that will be raised... 3 3. Estimating the marginal

More information

EMBA in Management & Finance. Corporate Finance. Eric Jondeau

EMBA in Management & Finance. Corporate Finance. Eric Jondeau EMBA in Management & Finance Corporate Finance EMBA in Management & Finance Lecture 5: Capital Budgeting For the Levered Firm Prospectus Recall that there are three questions in corporate finance. The

More information

Investments, Chapter 4

Investments, Chapter 4 Investments, Chapter 4 Answers to Selected Problems 2. An open-end fund has a net asset value of $10.70 per share. It is sold with a front-end load of 6 percent. What is the offering price? Answer: When

More information

Homework Solutions - Lecture 2

Homework Solutions - Lecture 2 Homework Solutions - Lecture 2 1. The value of the S&P 500 index is 1286.12 and the treasury rate is 3.43%. In a typical year, stock repurchases increase the average payout ratio on S&P 500 stocks to over

More information

CHAPTER 14 COST OF CAPITAL

CHAPTER 14 COST OF CAPITAL CHAPTER 14 COST OF CAPITAL Answers to Concepts Review and Critical Thinking Questions 1. It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this,

More information

MM1 - The value of the firm is independent of its capital structure (the proportion of debt and equity used to finance the firm s operations).

MM1 - The value of the firm is independent of its capital structure (the proportion of debt and equity used to finance the firm s operations). Teaching Note Miller Modigliani Consider an economy for which the Efficient Market Hypothesis holds and in which all financial assets are possibly traded (abusing words we call this The Complete Markets

More information

CHAPTER 20. Hybrid Financing: Preferred Stock, Warrants, and Convertibles

CHAPTER 20. Hybrid Financing: Preferred Stock, Warrants, and Convertibles CHAPTER 20 Hybrid Financing: Preferred Stock, Warrants, and Convertibles 1 Topics in Chapter Types of hybrid securities Preferred stock Warrants Convertibles Features and risk Cost of capital to issuers

More information

USING THE EQUITY RESIDUAL APPROACH TO VALUATION: AN EXAMPLE

USING THE EQUITY RESIDUAL APPROACH TO VALUATION: AN EXAMPLE Graduate School of Business Administration - University of Virginia USING THE EQUITY RESIDUAL APPROACH TO VALUATION: AN EXAMPLE Planned changes in capital structure over time increase the complexity of

More information

SAMPLE FACT EXAM (You must score 70% to successfully clear FACT)

SAMPLE FACT EXAM (You must score 70% to successfully clear FACT) SAMPLE FACT EXAM (You must score 70% to successfully clear FACT) 1. What is the present value (PV) of $100,000 received five years from now, assuming the interest rate is 8% per year? a. $600,000.00 b.

More information

Lecture 15: Final Topics on CAPM

Lecture 15: Final Topics on CAPM Lecture 15: Final Topics on CAPM Final topics on estimating and using beta: the market risk premium putting it all together Final topics on CAPM: Examples of firm and market risk Shorting Stocks and other

More information

CHAPTER 22: FUTURES MARKETS

CHAPTER 22: FUTURES MARKETS CHAPTER 22: FUTURES MARKETS PROBLEM SETS 1. There is little hedging or speculative demand for cement futures, since cement prices are fairly stable and predictable. The trading activity necessary to support

More information

Expected default frequency

Expected default frequency KM Model Expected default frequency Expected default frequency (EDF) is a forward-looking measure of actual probability of default. EDF is firm specific. KM model is based on the structural approach to

More information

WACC and APV. The Big Picture: Part II - Valuation

WACC and APV. The Big Picture: Part II - Valuation WACC and APV 1 The Big Picture: Part II - Valuation A. Valuation: Free Cash Flow and Risk April 1 April 3 Lecture: Valuation of Free Cash Flows Case: Ameritrade B. Valuation: WACC and APV April 8 April

More information

COST OF CAPITAL Compute the cost of debt. Compute the cost of preferred stock.

COST OF CAPITAL Compute the cost of debt. Compute the cost of preferred stock. OBJECTIVE 1 Compute the cost of debt. The method of computing the yield to maturity for bonds will be used how to compute the cost of debt. Because interest payments are tax deductible, only after-tax

More information

Ch. 18: Taxes + Bankruptcy cost

Ch. 18: Taxes + Bankruptcy cost Ch. 18: Taxes + Bankruptcy cost If MM1 holds, then Financial Management has little (if any) impact on value of the firm: If markets are perfect, transaction cost (TAC) and bankruptcy cost are zero, no

More information

The Tangent or Efficient Portfolio

The Tangent or Efficient Portfolio The Tangent or Efficient Portfolio 1 2 Identifying the Tangent Portfolio Sharpe Ratio: Measures the ratio of reward-to-volatility provided by a portfolio Sharpe Ratio Portfolio Excess Return E[ RP ] r

More information

MBA 8230 Corporation Finance (Part II) Practice Final Exam #2

MBA 8230 Corporation Finance (Part II) Practice Final Exam #2 MBA 8230 Corporation Finance (Part II) Practice Final Exam #2 1. Which of the following input factors, if increased, would result in a decrease in the value of a call option? a. the volatility of the company's

More information

Problem 1 (Issuance and Repurchase in a Modigliani-Miller World)

Problem 1 (Issuance and Repurchase in a Modigliani-Miller World) Problem 1 (Issuance and Repurchase in a Modigliani-Miller World) A rm has outstanding debt with a market value of $100 million. The rm also has 15 million shares outstanding with a market value of $10

More information

INTERVIEWS - FINANCIAL MODELING

INTERVIEWS - FINANCIAL MODELING 420 W. 118th Street, Room 420 New York, NY 10027 P: 212-854-4613 F: 212-854-6190 www.sipa.columbia.edu/ocs INTERVIEWS - FINANCIAL MODELING Basic valuation concepts are among the most popular technical

More information

Cost of Capital. Katharina Lewellen Finance Theory II April 9, 2003

Cost of Capital. Katharina Lewellen Finance Theory II April 9, 2003 Cost of Capital Katharina Lewellen Finance Theory II April 9, 2003 What Next? We want to value a project that is financed by both debt and equity Our approach: Calculate expected Free Cash Flows (FCFs)

More information

CHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING

CHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING CHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING Answers to Concepts Review and Critical Thinking Questions 1. No. The cost of capital depends on the risk of the project, not the source of the money.

More information

PRACTICE EXAM QUESTIONS ON WACC

PRACTICE EXAM QUESTIONS ON WACC Dr. Sudhakar Raju Financial Statements Analysis (FN 6450) PRACTICE EXAM QUESTIONS ON WACC 1. The return shareholders require on their investment in a firm is called the: a. dividend yield. B. cost of equity.

More information

CHAPTER 17 Does Debt Policy Matter?

CHAPTER 17 Does Debt Policy Matter? CHPTR 17 Does Debt Policy Matter? nswers to Practice Questions 1. a. The two firms have equal value; let represent the total value of the firm. Rosencrantz could buy one percent of Company B s equity and

More information

FIN 413 Corporate Finance. Capital Structure, Taxes, and Bankruptcy

FIN 413 Corporate Finance. Capital Structure, Taxes, and Bankruptcy FIN 413 Corporate Finance Capital Structure, Taxes, and Bankruptcy Evgeny Lyandres Fall 2003 1 Relaxing the M-M Assumptions E D T Interest payments to bondholders are deductible for tax purposes while

More information

Final Exam Practice Set and Solutions

Final Exam Practice Set and Solutions FIN-469 Investments Analysis Professor Michel A. Robe Final Exam Practice Set and Solutions What to do with this practice set? To help students prepare for the final exam, three practice sets with solutions

More information

Forecasting and Valuation of Enterprise Cash Flows 1. Dan Gode and James Ohlson

Forecasting and Valuation of Enterprise Cash Flows 1. Dan Gode and James Ohlson Forecasting and Valuation of Enterprise Cash Flows 1 1. Overview FORECASTING AND VALUATION OF ENTERPRISE CASH FLOWS Dan Gode and James Ohlson A decision to invest in a stock proceeds in two major steps

More information

EMERSON AND SUBSIDIARIES CONSOLIDATED OPERATING RESULTS (AMOUNTS IN MILLIONS EXCEPT PER SHARE, UNAUDITED)

EMERSON AND SUBSIDIARIES CONSOLIDATED OPERATING RESULTS (AMOUNTS IN MILLIONS EXCEPT PER SHARE, UNAUDITED) CONSOLIDATED OPERATING RESULTS (AMOUNTS IN MILLIONS EXCEPT PER SHARE, UNAUDITED) TABLE 1 Quarter Ended March 31, Percent Change Net Sales $ 5,854 $ 5,919 1% Costs and expenses: Cost of sales 3,548 3,583

More information

Copyright 2009 Pearson Education Canada

Copyright 2009 Pearson Education Canada The consequence of failing to adjust the discount rate for the risk implicit in projects is that the firm will accept high-risk projects, which usually have higher IRR due to their high-risk nature, and

More information

Chapter 1: The Modigliani-Miller Propositions, Taxes and Bankruptcy Costs

Chapter 1: The Modigliani-Miller Propositions, Taxes and Bankruptcy Costs Chapter 1: The Modigliani-Miller Propositions, Taxes and Bankruptcy Costs Corporate Finance - MSc in Finance (BGSE) Albert Banal-Estañol Universitat Pompeu Fabra and Barcelona GSE Albert Banal-Estañol

More information

a) The Dividend Growth Model Approach: Recall the constant dividend growth model for the price of a rm s stock:

a) The Dividend Growth Model Approach: Recall the constant dividend growth model for the price of a rm s stock: Cost of Capital Chapter 14 A) The Cost of Capital: Some Preliminaries: The Security market line (SML) and capital asset pricing model (CAPM) describe the relationship between systematic risk and expected

More information

Napoli Pizza wants to determine its optimal capital structure

Napoli Pizza wants to determine its optimal capital structure Napoli Pizza wants to determine its optimal capital structure ABSTRACT Brad Stevenson Daniel Bauer David Collins Keith Richardson This case is based on an actual business decision that was made by a small,

More information

( ) ( )( ) ( ) 2 ( ) 3. n n = 100 000 1+ 0.10 = 100 000 1.331 = 133100

( ) ( )( ) ( ) 2 ( ) 3. n n = 100 000 1+ 0.10 = 100 000 1.331 = 133100 Mariusz Próchniak Chair of Economics II Warsaw School of Economics CAPITAL BUDGETING Managerial Economics 1 2 1 Future value (FV) r annual interest rate B the amount of money held today Interest is compounded

More information

CHAPTER 11 Questions and Problems

CHAPTER 11 Questions and Problems 1 CHAPTER 11 Questions and Problems (In the problems below, you can use a risk premium of 5.5% and a tax rate of 40% if either is not specified) 1. Stock buybacks really do not return cash to stockholders,

More information

Homework Assignment #1: Answer Key

Homework Assignment #1: Answer Key Econ 497 Economics of the Financial Crisis Professor Ickes Spring 2012 Homework Assignment #1: Answer Key 1. Consider a firm that has future payoff.supposethefirm is unlevered, call the firm and its shares

More information

Q3: What is the quarterly equivalent of a continuous rate of 3%?

Q3: What is the quarterly equivalent of a continuous rate of 3%? SESSION 1: Pre-requisites: a reminder Time value of money, annuities Q1: You wish to buy a new house but would need to borrow part of the required amount. In view of your revenues you have been able to

More information

Fundamentals Level Skills Module, Paper F9

Fundamentals Level Skills Module, Paper F9 Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2008 Answers 1 (a) Calculation of weighted average cost of capital (WACC) Cost of equity Cost of equity using capital asset

More information

MCQ on Financial Management

MCQ on Financial Management MCQ on Financial Management 1. "Shareholder wealth" in a firm is represented by: a) the number of people employed in the firm. b) the book value of the firm's assets less the book value of its liabilities

More information

Chapter 16 Financial Distress, Managerial Incentives, and Information

Chapter 16 Financial Distress, Managerial Incentives, and Information Chapter 16 Financial Distress, Managerial Incentives, and Information 16-1. Gladstone Corporation is about to launch a new product. Depending on the success of the new product, Gladstone may have one of

More information

STATUTORY BOARD SB-FRS 32 FINANCIAL REPORTING STANDARD. Financial Instruments: Presentation Illustrative Examples

STATUTORY BOARD SB-FRS 32 FINANCIAL REPORTING STANDARD. Financial Instruments: Presentation Illustrative Examples STATUTORY BOARD SB-FRS 32 FINANCIAL REPORTING STANDARD Financial Instruments: Presentation Illustrative Examples CONTENTS Paragraphs ACCOUNTING FOR CONTRACTS ON EQUITY INSTRUMENTS OF AN ENTITY Example

More information

STATUTORY BOARD FINANCIAL REPORTING STANDARD SB-FRS 32. Financial Instruments: Presentation Illustrative Examples

STATUTORY BOARD FINANCIAL REPORTING STANDARD SB-FRS 32. Financial Instruments: Presentation Illustrative Examples STATUTORY BOARD FINANCIAL REPORTING STANDARD SB-FRS 32 Financial Instruments: Presentation Illustrative Examples CONTENTS Paragraphs ACCOUNTING FOR CONTRACTS ON EQUITY INSTRUMENTS OF AN ENTITY Example

More information

Estimating Cost of Capital. 2. The cost of capital is an opportunity cost it depends on where the money goes, not where it comes from

Estimating Cost of Capital. 2. The cost of capital is an opportunity cost it depends on where the money goes, not where it comes from Estimating Cost of Capal 1. Vocabulary the following all mean the same thing: a. Required return b. Appropriate discount rate c. Cost of capal (or cost of money) 2. The cost of capal is an opportuny cost

More information

Fundamentals Level Skills Module, Paper F9

Fundamentals Level Skills Module, Paper F9 Answers Fundamentals Level Skills Module, Paper F9 Financial Management December 2008 Answers 1 (a) Rights issue price = 2 5 x 0 8 = $2 00 per share Theoretical ex rights price = ((2 50 x 4) + (1 x 2 00)/5=$2

More information

CAPITAL STRUCTURE [Chapter 15 and Chapter 16]

CAPITAL STRUCTURE [Chapter 15 and Chapter 16] Capital Structure [CHAP. 15 & 16] -1 CAPITAL STRUCTURE [Chapter 15 and Chapter 16] CONTENTS I. Introduction II. Capital Structure & Firm Value WITHOUT Taxes III. Capital Structure & Firm Value WITH Corporate

More information

CLASS NOTES ON CORPORATE FINANCE. Copyright 1999 by Yossi Spiegel

CLASS NOTES ON CORPORATE FINANCE. Copyright 1999 by Yossi Spiegel Preliminary and highly incomplete CLASS NOTES ON CORPORATE FINANCE by Yossi Spiegel * Berglas School of Economics, Tel Aviv University Spring 1999 Copyright 1999 by Yossi Spiegel * Parts of these class

More information

Tax-adjusted discount rates with investor taxes and risky debt

Tax-adjusted discount rates with investor taxes and risky debt Tax-adjusted discount rates with investor taxes and risky debt Ian A Cooper and Kjell G Nyborg October 2005, first version October 2004 Abstract This paper derives tax-adjusted discount rate formulas with

More information

BUSINESS FINANCE (FIN 312) Spring 2008

BUSINESS FINANCE (FIN 312) Spring 2008 BUSINESS FINANCE (FIN 312) Spring 2008 Assignment 3 Instructions: please read carefully You can either do the assignment by yourself or work in a group of no more than two. You should show your work how

More information

Practice Bulletin No. 2

Practice Bulletin No. 2 Practice Bulletin No. 2 INTERNATIONAL GLOSSARY OF BUSINESS VALUATION TERMS To enhance and sustain the quality of business valuations for the benefit of the profession and its clientele, the below identified

More information

Tax-adjusted discount rates with investor taxes and risky debt

Tax-adjusted discount rates with investor taxes and risky debt Tax-adjusted discount rates with investor taxes and risky debt Ian A Cooper and Kjell G Nyborg October 2004 Abstract This paper derives tax-adjusted discount rate formulas with Miles-Ezzell leverage policy,

More information

Futures Price d,f $ 0.65 = (1.05) (1.04)

Futures Price d,f $ 0.65 = (1.05) (1.04) 24 e. Currency Futures In a currency futures contract, you enter into a contract to buy a foreign currency at a price fixed today. To see how spot and futures currency prices are related, note that holding

More information

Chapter 7: Capital Structure: An Overview of the Financing Decision

Chapter 7: Capital Structure: An Overview of the Financing Decision Chapter 7: Capital Structure: An Overview of the Financing Decision 1. Income bonds are similar to preferred stock in several ways. Payment of interest on income bonds depends on the availability of sufficient

More information

DCF and WACC calculation: Theory meets practice

DCF and WACC calculation: Theory meets practice www.pwc.com DCF and WACC calculation: Theory meets practice Table of contents Section 1. Fair value and company valuation page 3 Section 2. The DCF model: Basic assumptions and the expected cash flows

More information

Cost of Capital, Valuation and Strategic Financial Decision Making

Cost of Capital, Valuation and Strategic Financial Decision Making Cost of Capital, Valuation and Strategic Financial Decision Making By Dr. Valerio Poti, - Examiner in Professional 2 Stage Strategic Corporate Finance The financial crisis that hit financial markets in

More information

TPPE17 Corporate Finance 1(5) SOLUTIONS RE-EXAMS 2014 II + III

TPPE17 Corporate Finance 1(5) SOLUTIONS RE-EXAMS 2014 II + III TPPE17 Corporate Finance 1(5) SOLUTIONS RE-EXAMS 2014 II III Instructions 1. Only one problem should be treated on each sheet of paper and only one side of the sheet should be used. 2. The solutions folder

More information

Chapter 10 Risk and Capital Budgeting

Chapter 10 Risk and Capital Budgeting Chapter 10 Risk and Capital Budgeting MULTIPLE CHOICE 1. Operating leverage describes the relationship between... a. EBIT and sales b. taxes and sales c. debt and equity d. fixed costs and variable costs

More information

Finance 3130 Corporate Finiance Sample Final Exam Spring 2012

Finance 3130 Corporate Finiance Sample Final Exam Spring 2012 Finance 3130 Corporate Finiance Sample Final Exam Spring 2012 True/False Indicate whether the statement is true or falsewith A for true and B for false. 1. Interest paid by a corporation is a tax deduction

More information

Practice Questions for Midterm II

Practice Questions for Midterm II Finance 333 Investments Practice Questions for Midterm II Winter 2004 Professor Yan 1. The market portfolio has a beta of a. 0. *b. 1. c. -1. d. 0.5. By definition, the beta of the market portfolio is

More information

LOS 42.a: Define and interpret free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).

LOS 42.a: Define and interpret free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). The following is a review of the Equity Investments principles designed to address the learning outcome statements set forth by CFA Institute. This topic is also covered in: Free Cash Flow Valuation This

More information

Sample Problems Chapter 10

Sample Problems Chapter 10 Sample Problems Chapter 10 Title: Cost of Debt 1. Costly Corporation plans a new issue of bonds with a par value of $1,000, a maturity of 28 years, and an annual coupon rate of 16.0%. Flotation costs associated

More information