Show all your work in the space provided. If you need more space, use the space on the last page or, if necessary, attach another sheet of paper but be sure to indicate on these pages that your problem solution is continued elsewhere and state exactly where the answer continues. Total Credit: 2.5 points
Problem Chapter 14
1) Titan Mining Corporation has 8.5 million shares of common stock outstanding and $200,000,000 book value of 7.5 percent semiannual bonds outstanding. The common stock currently sells for $34 and has a beta of 1.2 and the bonds mature in ten years and are priced to yield 8.5% annually. The market risk premium is 7 percent, T-bills are yielding 5%, and Titan Mining’s tax rate is 35 percent.
(a) What if the firm’s market value capital structure. How do the market weights differ from the book value weights for the firm’s capital structure? Why are market weights better?
(b) If Titan Mining is evaluating a new investment project that has the same risk as the firm’s typical project, what rate should the firm use to discount the project’s cash flows?
(c) In what circumstances would this rate be inappropriate to discount the cash flows for a project undertaken by the firm?
Problems Chapter 16
2) This problem follows our discussion of the example in section 16.3 of the text and discussed in class, changing some numbers and assumptions. Assume that an unlevered firm Alpha is valued at $200,000, but that identical firm Beta has $100,000 in debt at 12% and that investors can borrow to buy stock at that rate. Follow the procedure used in class and use the following format for solving the problem to confirm your understanding of the M-M arbitrage argument concerning capital structure effects on firms’ values
(a) Calculate the net investment of cash to replicate cash flows from the ownership of 10% of Beta by buying 10% of Alpha with margin account loans. What must be the market value of Beta’s equity in no-arbitrage equilibrium? What are the expected returns on Alpha’s and Beta’s equity?
(b) What is the total market value of Alpha and Beta?
(c) What is the weighted-average cost of capital for Alpha and Beta?
(d) Explain carefully the role arbitrage plays in determining the answers in (b) and (c).
3) New School Corporation expects an EBIT of $25,000 with a corporate tax rate of 35% in perpetuity; there is no bankruptcy risk. New School’s cost of equity is 12.5% and it has no debt.
(a) What is the value of New School’s equity? What would be its WACC?
(b) Debt would cost New School 8% before tax. Suppose New School borrowed half of its unlevered value and bought back equity. What would be its total value (debt and equity)? What would be its WACC given both the tax deductibility of debt and the increased risk of equity returns?
(c) Imagine that New School borrowed 90% of its unlevered value and bought back equity. What would be its total value (debt and equity)? What would be its WACC given both the tax deductibility of debt and the increased risk of equity returns?
(d) Why is the answer to (c) not reasonable when there are bankruptcy risks?
4) You own 10,000 shares of Chirayos-Chung Corporation that pays $ .20 in dividends at the end of each year and is currently (time zero) valued at $5 per share. Investors expect the firm to earn 20% on shares. Assume that instead of $2,000 per year you need cash flows of $40,000 at the end of years 2 and 4. By creating “homemade dividends” and re-investing unneeded cash dividends, what will be the remainder of the cash value of your position in the firm be in year 4? (Note that the price of shares will increase at the expected return minus cash dividends.) Show all your calculations.
Problem from Chapter 17
5) Vulnerable Corporation, an all-equity corporation, has 10,000 shares priced at $5 per share. The firm is considering issuing debt valued at $25,000. The firm’s tax rate is 30%. The probability of the firm going into bankruptcy with this much debt is .1 (10%) and the cost of bankruptcy is expected to be 20% of the value of the debt plus $10,000 in legal costs, court fees, and expert analysis and a government claim of $10,000 for unpaid taxes. What is the total market value of the firm? If the firm reduced its bankruptcy risk to zero by reducing debt to $10,000, what would be the value of the firm?
STATEMENT BY GROUP MEMBERS:
The undersigned group members all contributed to the completion of this problem set and understand the source materials, basic techniques, and analysis used to answer these questions.
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