UNIT 1V ASSESSMENT
Bholman22
unit_iv_assessment.docx
1. Consider a project with free cash flows in one year of $143,797 or $169,506, with each outcome being equally likely. The initial investment required for the project is $96,628, and the project's cost of capital is 21%. The risk-free interest rate is 9%.
a. What is the NPV of this project?
The NPV is $ . (Round to the nearest dollar.)
b. Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. The equity holders will receive the cash flows of the project in one year. How much money can be raised in this —that is, what is the initial market value of the unlevered equity?
The initial market value of the unlevered equity is $ . (Round to the nearest dollar.)
c. Suppose the initial $96,628 is instead raised by borrowing at the risk-free interest rate. What are the cash flows of the levered equity, what is its initial value and what is the initial equity according to MM?
The cash flows of the levered equity and its initial values according to MM are: (Round to the nearest dollar.)
|
Date 0 |
Date 1 |
|||||
|
|
Initial Value |
Cash Flow Strong Economy |
Cash Flow Weak Economy |
|||
|
Debt |
$96,628 |
|
$ |
|
$ |
|
|
Levered Equity |
$ |
|
$ |
|
$ |
|
2. Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $3,000
on which it pays interest of 10% each year. Both companies have identical projects that generate free cash flows of $3,500 or $3,100 each year. After paying any interest on debt, both companies use all remaining free cash flows to pay dividends each year
a. In the table below, fill in the debt payments for each firm and the dividend payments the equity holders of each firm will receive given each of the two possible levels of free cash flows. (Round all answers to the nearest dollar.)
|
|
ABC |
XYZ |
||
|
FCF |
Debt Payments |
Equity Dividends |
Debt Payments |
Equity Dividends |
|
$3,500 |
$ |
$ |
$ |
$ |
|
$3,100 |
$ |
$ |
$ |
$ |
b. If you hold 10% of the equity of ABC, another portfolio you could hold that would provide the same cash flows would be: (Select from the drop-down menus and round to the nearest integer.)
▼
Buy
Sell
%
of
▼
XYZ
ABC
debt, and
▼
sell
buy
%
of
▼
XYZ
ABC
equity.
c. If you hold 10%
of the equity of XYZ and can borrow at the same terms as XYZ, an alternative strategy that would provide the same cash flows would be: (Select from the drop-down menus and round to the nearest integer.)
▼
Lend
Borrow
an amount equal to
%
of
▼
ABC
XYZ
debt, and
▼
sell
buy
%
of
▼
ABC
XYZ
Equity
3. Explain what is wrong with the following argument: "If a firm issues debt that is risk free, because there is no possibility of default, the risk of the firm's equity does not change. Therefore, risk-free debt allows the firm to get the benefit of a low cost of capital of debt without raising its cost of capital of equity."
(Select the best choice below.)
A.The argument is correct.
B.The argument is wrong because any leverage raises the equity cost of capital. Risk-free leverage raises it the most because it does not share any of the risk.
C.The argument is wrong because any leverage raises the equity cost of capital. Risk-free leverage raises it the least because it does not share any of the risk.
D.The argument is correct because debt has a lower cost of capital than equity and a firm can reduce its overall weighted average cost of capital by increasing the amount of debt financing
4. Indell stock has a current market value of $150 million and a beta of 0.50. Indell currently has risk-free debt as well. The firm decides to change its capital structure by issuing
$43.51 million in additional risk-free debt, and then using this $43.51 million plus another
$10 million in cash to repurchase stock. With perfect capital markets, what will the beta of Indell stock be after this transaction?
The beta of Indell stock after the recapitalization is . (Round to two decimal places.)
5. Zelnor, Inc., is an all-equity firm with 100 million shares outstanding currently trading for $8.50
per share. Suppose Zelnor decides to grant a total of 10 million new shares to employees as part of a new compensation plan. The firm argues that this new compensation plan will motivate employees and is better than giving salary bonuses because it will not cost the firm anything. Assume perfect capital markets.
a. If the new compensation plan has no effect on the value of Zelnor's assets, what will be the share price of the stock once this plan is implemented?
If the new compensation plan has no effect on the value of Zelnor's assets, the new share price will be
$ . (Round to the nearest cent.)
b. What is the cost of this plan for Zelnor investors? Why is issuing equity costly in this case?
The cost to investors is
$ million. (Round to the nearest million)
Why is issuing equity costly in this case? (Select the best choice below.)
A.It is not costly because we are not taking into account the benefit of the equity to the employees. Once that is accounted for, the value of the firm will be the same.
B.This is a standard example of the effect of dilution on the share price which is always costly.
C.It's costly because the shareholder equity is being given away to employees for free.
D.It only appears costly—the value of the firm as a whole is unchanged
|
Settings
|
6. Grommit Engineering expects to have net income next year of $30.02 million and free cash flow of $15.01 million. Grommit's marginal corporate tax rate is 40%
a. If Grommit increases leverage so that its interest expense rises by $3.5 million, how will net income change?
If Grommit increases leverage so that its interest expense rises by $3.5 million, the net income will fall to
$ million. (Round to two decimal places.)
b. For the same increase in interest expense, how will free cash flow change?
For the same increase in interest expense, how will free cash flow change? (Select the best choice below.)
A.Free cash flow increases by the amount of the interest expense.
B.Free cash flow decreases by the amount of the interest expense.
C.Free cash flow is not affected by interest expense.
D.None of the above.
7. Your firm currently has $100 million in debt outstanding with a 9% interest rate. The terms of the loan require the firm to repay $25 million of the balance each year. Suppose that the marginal corporate tax rate is 35%, and that the interest tax shields have the same risk as the loan. What is the present value of the interest tax shields from this debt?
The present value of the interest tax shields is $ million. (Round to two decimal places.)
|
Skill Builder Question Help
Settings
|
8. Markum Enterprises is considering permanently adding an additional $156 million of debt to its capital structure. Markum's corporate tax rate is 40%
a. Absent personal taxes, what is the value of the interest tax shield from the new debt?
In the absence of personal taxes, the value of interest tax shield from new debt should be
$ million. (Round to two decimal places.)
b. If investors pay a tax rate of 35% on interest income, and a tax rate of 30%
on income from dividends and capital gains, what is the value of the interest tax shield from the new debt?
If investors pay a tax rate of 35% on interest income, and a tax rate of 30%
on income from dividends and capital gains, the value of the interest tax shield from new debt should be
$ million. (Round to two decimal places.)
|
Skill Builder Question Help
Settings
|
9. Gladstone Corporation is about to launch a new product. Depending on the success of the new product, Gladstone may have one of four values next year: $150 million, $135 million, $95 million, and $80 million. These outcomes are all equally likely, and this risk is diversifiable. Gladstone will not make any payouts to investors during the year. Suppose the risk-free interest rate is 5.0% and assume perfect capital markets.
a. What is the initial value of Gladstone's equity without leverage?
The initial value of Gladstone's equity without leverage is $ million. (Round to two decimal places.)
Now suppose Gladstone has zero-coupon debt with a $100 million face value due next year.
b. What is the initial value of Gladstone's debt?
The initial value of Gladstone's debt is $ million. (Round to two decimal places.)
c. What is the yield-to-maturity of the debt? What is its expected return?
The yield-to-maturity is %. (Round to the nearest integer.)
The expected return is %. (Round to one decimal place.)
d. What is the initial value of Gladstone's equity? What is Gladstone's total value with leverage?
The initial value of Gladstone's levered equity is $ million. (Round to two decimal places.)
Gladstone's total value with leverage is $ million. (Round to two decimal places.)
10. Which type of firm is more likely to experience a loss of customers in the event of financial distress:
a. Campbell Soup Company or Intuit, Inc. (a maker of accounting software)?
In the event of financial distress, which company is more likely to experience a loss of customers? (Select the best choice below.)
Campbell Soup Company
Intuit, Inc.
b. Allstate Corporation (an insurance company) or Adidas AG (maker of athletic footwear, apparel, and sports equipment)?
In the event of financial distress, which company is more likely to experience a loss of customers? (Select the best choice below.)
Allstate Corporation
Reebok International
|
Settings
|
11. Hawar International is a shipping firm with a current share price of $5.50 and 10 million shares outstanding. Suppose Hawar announces plans to lower its corporate taxes by borrowing $20 million and repurchasing shares.
a. With perfect capital markets, what will the share price be after this announcement?
With perfect capital markets, the share price will be $ per share. (Round to the nearest cent.)
Suppose that Hawar pays a corporate tax rate of 30%, and that shareholders expect the change in debt to be permanent.
b. If the only imperfection is corporate taxes, what will the share price be after this announcement?
If the only imperfection is corporate taxes, the share price will be
$ per share. (Round to the nearest cent.)
c. Suppose the only imperfections are corporate taxes and financial distress costs. If the share price rises to $5.75
after this announcement, what is the PV of financial distress costs Hawar will incur as the result of this new debt?
If the share price rises to $5.75
after this announcement, the PV of financial distress costs Hawar will incur as the result of this new debt will be $ million. (Round to two decimal places.)
12. Although the major benefit of debt financing is easy to observe—the tax shield—many
of the indirect costs of debt financing can be quite subtle and difficult to observe. Describe some of these costs.(Select from the drop-down menus.)
A.Overinvestment: Investing in negative NPV projects.
B.Overinvestment: Highly leveraged firms run the risk of bankruptcy and so cannot write long term employment contracts and offer job security.
C.Overinvestment: Not investing in positive NPV projects
D.Overinvestment: Paying out dividends instead of investing in positive NPV projects.
(Select from the drop-down menus.)
A.Underinvestment: Highly leveraged firms run the risk of bankruptcy and so cannot write long term employment contracts and offer job security.
B.Underinvestment: Not investing in positive NPV projects
C.Underinvestment: Investing in negative NPV projects.
D.Underinvestment: Paying out dividends instead of investing in positive NPV projects.
(Select from the drop-down menus.)
A.Cashing out: Highly leveraged firms run the risk of bankruptcy and so cannot write long term employment contracts and offer job security.
B.Cashing out: Investing in negative NPV projects.
C.Cashing out: Paying out dividends instead of investing in positive NPV projects.
D.Cashing out: Not investing in positive NPV projects
(Select from the drop-down menus.)
A.Employee job security: Highly leveraged firms run the risk of bankruptcy and so cannot write long term employment contracts and offer job security.
B.Employee job security: Investing in negative NPV projects.
C.Employee job security: Paying out dividends instead of investing in positive NPV projects.
D.Employee job security: Not investing in positive NPV projects.
|
Settings
|
13. Describe the different mechanisms available to a firm for repurchasing shares.
There are three mechanisms: (Select the best choice below.)
A. 1) In an open market repurchase, the firm repurchases the shares in the open market. This is the most common mechanism in the United States.
B. 2) In a tender offer, the firm announces the intention to all shareholders to repurchase a fixed number of shares for a fixed price, conditional on shareholders agreeing to tender their shares. If not enough shares are tendered, the deal can be cancelled.
C. 2) In a tender offer, the firm announces the intention to repurchase a fixed number of shares for a fixed price, conditional on shareholders agreeing to tender their shares. Even if not enough shares are tendered, the firm is obligated to repurchase the shares that are tendered.
D. 3) A targeted repurchase is similar to a tender offer except that it is not open to all shareholders; only specific shareholders can tender their shares in a targeted repurchase
|
Settings
|
14. KMS Corporation has assets with a market value of $500 million, $50 million of which are cash. It has debt of $200 million, and 10 million shares outstanding. Assume perfect capital markets
a. What is its current stock price?
KMS Corporation's current stock price is $ per share. (Round to the nearest cent.)
b. If KMS distributes $50 million as a dividend, what will its share price be after the dividend is paid?
If KMS distributes $50
million as a dividend, KMS Corporation's share price after the dividend is paid will be
$ per share. (Round to the nearest cent.)
c. If instead, KMS distributes $50 million as a share repurchase, what will its share price be once the shares are repurchased?
If instead, KMS distributes $50 million as a share repurchase, KMS Corporation's share price after the shares are repurchased will be $ per share. (Round to the nearest cent.)
d. What will its new market debt-equity ratio be after either transaction?
After either transaction, the debt-to-equity ratio is . (Round to two decimal places.)
15. Using the table (see attached) for each of the following years, state whether dividends were tax disadvantaged or not for individual investors with a one-year investment horizon:
a. 1985 (Select from the drop-down menu.)
1985:
▼
disadvantaged
not disadvantaged
.
b. 1989 (Select from the drop-down menu.)
1989:
▼
disadvantaged
not disadvantaged
.
c. 1995 (Select from the drop-down menu.)
1995:
▼
disadvantaged
not disadvantaged
.
d. 1999 (Select from the drop-down menu.)
1999:
▼
disadvantaged
not disadvantaged
.
e. 2005 (Select from the drop-down menu.)
2005:
▼
disadvantaged
not disadvantaged
16. When might it be advantageous to undertake a reverse stock split?
(Select the best choice below.)
A.To avoid being delisted from an exchange because the price of the stock has fallen below the minimum share price required to stay listed.
B.When the stock price is over $100.
C. In bad times, to signal future good times.
D. There is no good reason to do a reverse stock split—just ask Warren Buffet.
.
0
