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Advanced Corporate Finance

Prof. Fernando

These practice questions are designed to help you better understand the material covered in class and prepare for the exams. These questions do not carry a grade (since your knowledge will be tested in the exams) and you are not required to turn them in. We will be placing the solutions on the website shortly. It is in your interest to attempt these questions individually before discussing them with your colleagues or looking at the solutions. Practice Question Set 1 1. An all-equity firm is subject to a 30% tax rate. Its total market value is initially $3,500,000. There are 175,000 shares outstanding. The firm announces a program to issue $1 million worth of bonds at 10% interest and use the proceeds to buy back common stock. Assume no change in costs of financial distress and that the debt is perpetual. What is the value of the tax shield that the firm acquires through the bond issue? According to Modigliani-Miller, what is the likely increase in market value per share of the firm after the announcement, assuming efficient markets? How many shares will the company be able to repurchase? 2. A firm has the choice of investing in one of two projects. Both projects last one year. Project 1 requires an investment of $11000 and yields $11000 with a probability of 0.5 and $13000 with a probability of 0.5. Project 2 also requires an investment of $11000 and yields $5000 with a probability of 0.5 and $20000 with a probability of 0.5. The firm is capable of raising $10000 of the investment required through a bond issue which carries an annual interest rate of 10%. Which project would stockholders prefer? Why? Which project would bondholders prefer? Why? Assume that the investors are only concerned about expected returns. An all-equity firm has 100,000 shares outstanding worth $10 each. The firm is considering a project which requires an investment of $400,000 and has a NPV of $50,000, and is considering financing this project with a new issue of equity. a) What is the price at which the firm needs to issue the new shares so that the existing shareholders are indifferent between taking on the project with this equity financing, and not taking on the project?

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b)

What is the price at which the firm needs to issue the new shares so that the existing shareholders capture the full benefit associated with the new project?

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Levered, Inc., and Unlevered, Inc., are identical companies with identical business risk. Their earnings are perfectly correlated. Each company is expected to earn $96 million year in perpetuity, and each company distributes all its earnings. Levered's debt has a value of $275 million and provides a return of 8 percent. Levered's stock sells for $100 per share, and there are 4.5 million outstanding shares. Unlevered has only 10 million outstanding shares worth $80 each. Unlevered has no debt. There are no taxes. Which stock is a better investment? The Nikko Company has perpetual EBIT of $4 million per year. The after-tax, allequity discount rate r0 is 15 percent. The company's tax rate is 35 percent. The cost of debt capital is 10 percent, and Nikko has $10 million of debt in its capital structure. a. What is Nikko's value? b. What is Nikko's rWACC? c. What is Nikko's cost of equity?

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6.

Honda and GM are competing to sell a fleet of cars to Hertz. Hertz's policies on its rental cars include use of straight-line depreciation and disposing of the cars after five years. Hertz expects that the autos will have no salvage value. The firm expects a fleet of 25 cars to generate $100,000 per year in pretax income. Hertz is in the 34-percent tax bracket, and the firm's overall required return is 10 percent. The addition of the new fleet will not add to the risk of the firm. Treasury bills are priced to yield 6 percent. a. What is the maximum price that Hertz should be willing to pay for the fleet of cars? Assume that Hertz is initially all-equity financed and that the depreciation tax shield can be discounted at the Treasury bill rate. b. Suppose the price of the fleet (in U.S. dollars) is $325,000; both suppliers are charging this price. Hertz is able to issue $200,000 in debt to finance the project. The bonds can be issued at par and will carry an 8-percent interest rate. Hertz will incur no costs to issue the debt and no costs of financial distress. What is the APV of this project if Hertz uses debt to finance the auto purchase? c. To entice Hertz to buy the cars from Honda, the Japanese government is willing to lend Hertz $200,000 at 5 percent. Now what is the maximum price that Hertz is willing to pay Honda for the fleet of cars? For Part c note that the loan cash flows still need to be discounted by the market rate of debt. Also note that in this case, the loan creates two sources of value due to the subsidized discount rate and due to the tax shield.

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National Electric Company (NEC) is considering a $20 million modernization expansion project in the power systems division. Tom Edison, the company's chief financial officer, has evaluated the project; he determined that the project's after-tax cash flows will be $8 million, in perpetuity. In addition, Mr. Edison has devised two possibilities for raising the necessary $20 million: Issue 10-year, 10-percent debt. Issue common stock. NEC's cost of debt is 10 percent, and its cost of equity is 20 percent. The firm's target debt-equity ratio is 200 percent. The expansion project has the same risk as the existing business, and it will support the same amount of debt. NEC is in the 34-percent tax bracket. Mr. Edison has advised the firm to undertake the expansion. He suggests they use debt to finance the project because it is cheaper and its issuance costs are lower. a. Should NEC accept the project? Support your answer with the appropriate calculations. b. Do you agree with Mr. Edison's opinion of the expense of the debt? Why or why not?

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Folgers Air Transport (FAT) is currently an unleveraged firm. It is considering a capital restructuring to allow $500 in debt. The company expects to generate $151.52 in cash flows before interest and taxes, in perpetuity. Its cost of debt capital is 10 percent and the corporate tax rate is 34 percent. Unleveraged firms in the same industry have a cost of equity capital of 20 percent. Using WACC and APV, what will be the new value of FAT?