(Section C: Total marks 10)

Q1. Ltd firm is a publicly traded chemical company with 200 million shares trading at $ 20 a share
and $ 1 billion in outstanding debt; the market interest rate on the debt is 7%. The firm has a cost
of capital of 10.44%, the marginal tax rate is 40%, and the current equity beta is 1.75. The firm is
considering issuing new equity and retiring all of its debt. Estimate the new value for the firm if it
goes through with this transaction? (The risk-free rate is 5% and the market risk premium is 4%.
You can also assume no growth in perpetuity). (Hint: Saving of cost of financing) (Marks 6)

Solution

Current market value of equity = 4000

Market value of debt = 1000
Value of firm = 5000

Cost of capital = 10.44% = Cost of

equity (.80) + 4.2% (.20)
Cost of equity = 0.12
Current beta = 1.75

After debt is repaid

New beta = 1.52173913 =1.75/(1+(1-0.4)*(2/8))
New cost of equity = 11.09% ! Equal to cost of capital =5+4*1.52

! Change in firm value =

New firm value = $4,708.24 (.1044-.1109) 5000/.1109

1. Error in estimating current cost of equity: -0.5

2. Did not unlever beta: -0.5
3. Estimated new cost of equity wrong: -0.5
4. Used old cost of equity instead of capital in computing firm value change: -0.5
5. Did not compute PV of annual savings: -0.5
6. Did not compute change in firm value at all: -1
Each question 1 mark
2. A firm has an unlevered cost of capital of 10 percent, a cost of debt of 9 percent, and a tax rate
of 34 percent. If it desires a cost of equity of 14 percent, what must its target debt/equity ratio be?
A. 2.49
B. 3.89
C. 4.68
D. 5.14
E. 6.06
3. Klarman Inc. reported $150 million as net income on revenues of $1 billion in the most recent
year; capital expenditures were $100 million, depreciation was $60 million and non-cash working
capital was $80 million. Its revenues, earnings, capital expenditures and depreciation are expected
to grow 10% next year, while non-cash working capital will remain at the same percent of revenues
that it was in the most recent year. If Klarman pays out 60% of its earnings as dividends and
currently has a cash balance of $200 million, what will its cash balance be at the end of next year?
A. $188 million
B. $214 million
C. $242 million d. $260 million
D. None of the above
4. You are an activist investor looking to put pressure on companies that have accumulated too
much cash to return cash to stockholders. Which of the following companies would you put the
most pressure on to return cash? (You can assume that they all have a cost of capital of 10% and
an optimal debt ratio of 40%)
A. Company A: ROC = 25%, Actual debt ratio = 40%
B. Company B: ROC =25%, Actual debt ratio = 60%
C. Company C: ROC = 25%, Actual debt ratio = 10%
D. Company D: ROC = 5%, Actual debt ratio = 40%
E. Company E: ROC =5%, Actual debt ratio = 60%
F. Company F: ROC = 5%, Actual debt ratio = 10%
5. All else equal, which of the following are correct concerning stock splits and stock dividends?
All of the statements refer to book values, not market values.
I. The par value of the stock will change only with the stock split.
II. Total owners' equity will not change with either a stock split or a stock dividend.
III. The primary effect of either is to increase the number of shares outstanding.
IV. Earnings per share will likely decrease only with the stock dividend.
A. I and III only
B. II and IV only
C. I and II only
D. I, II and III only
E. I, II, III and IV