Problem
Set # 4
(due
4/27,
4 p.m.)
1.
Jussainoe Inc., a pharmaceutical company operating in perfect capital
markets, has debt with annual interest payments of $275,000 forever.
If the firm had remained unlevered, the required return on its equity would be
10.8%, and its value would be $6,200,000.
The required return on the firm’s debt is 7.9%. (Assume all cashflows are perpetuities.)
a)
What is the expected cashflow to stockholders, the value of equity and the
required return on equity?
b) Compute the required return on equity by a different way.
c)
Suppose the debt-to-value ratio falls to half its previous value.
What is the new WACC?
(12
points)
2. A
levered firm has a promised debt payment of $10,500 at time 1.
Their existing assets will generate the following cashflows at time 1:
State
of Economy Probability
Cashflows
Great 0.5
16,000
Okay 0.3
11,900
Poor
0.2
7,000
The firm also has a project that it
can invest in today. The project
requires an investment of $1,100 and will generate the following expected
cashflows:
State
of Economy Probability
Cashflows
Great 0.5
750
Okay
0.3
1,500
Poor
0.2
3,000
Assume
a risk-neutral world, with a discount rate of 6%.
a)
What is the NPV of the project?
b)
If the firm accepts the project, by how much will the wealth of bondholders
increase or decrease? Explain what makes the
c) Will stockholders invest in this project?
(18 points)
3
a) A levered firm operates in a world with just corporate taxes and no other
imperfections. They have a
debt-to-value ratio of 30%, a required return on assets of 11.6%, and a cost of
equity of 13.3%. The marginal tax
rate is 35%. The annual cashflows
generated by assets are $365,000 forever.
Compute the following:
i)
value of the firm
ii)
value of the debt (computed two different ways)
iii)
value of equity
iv)
WACC
v)
after-tax
cost of debt
b)
The firm's debt-to-equity ratio (not D/V) now changes to 62.5%.
How do your answers to part a change?
(20
points)
4.
A levered firm has expected cashflows of $1,675,000 each year forever.
The required return on their debt is 8.6%, and the annual interest
payments are $579,000 each year forever.
If the firm had no debt, the required return on its equity would be
12.5%. The
firm's marginal tax rate is 35% and the marginal personal tax rate is 28% on
ordinary income and 13% on equity income.
a)
What is the value of equity?
b)
What is the annual cashflow to stockholders?
c) Now assume that the firm changes its capital structure in such a way that the WACC falls by 5% (i.e. to 95% of what it was before). What is the new value of debt?
(15
points)
5.
Fill in the blanks in the table below (assuming
that T’ is 22%):
D/V
Ra
Re Rd
WACC
Firm A
.18 12.34%
-
5.7%
-
Firm B
-
11.11%
12.93%
- 9.87%
Firm C
.36
- 13.80%
6.3%
-
b)
Now assume you are estimating
the WACC for a new project, and these are three firms in the same industry.
If the project will have a
market value D/V ratio of 25%, what is estimated WACC of the project?
(15
points)
6.
Sethlet Enterprises is launching a new project, which requires an
investment
of $175,000. The project will generate operating cashflows of $18,000
forever. The investment will be
financed 45% by internal funds, 35% by new debt and 20% by new equity.
Issue costs are 5% for equity and 3% for debt. If the project had been
all-equity financed, its cost of capital would be 10.6%.
Assume that T’ is 20%.
a)
What is the project’s weighted average cost of capital?
b)
What is the adjusted NPV of the project, taking the impact of debt financing and
issue costs into account?
(15
points)