Posted: March 3rd, 2014
2. Illinois Industries has decided to borrow money by issuing perpetual bonds with a coupon rate of 10 percent, payable annually. The one-year interest rate is 10 percent. Next year, there is a 30 percent probability that interest rates will increase to 12 percent, and there is a 70 percent probability that they will fall to 6 percent.
| 2. Illinois Industries has decided to borrow money by issuing perpetual bonds with a coupon rate of 10 percent, payable annually. The one-year interest rate is 10 percent. Next year, there is a 30 percent probability that interest rates will increase to 12 percent, and there is a 70 percent probability that they will fall to 6 percent. |
| Required: |
| (a) | What will the market value of these bonds be if they are noncallable?(Do not include the dollar sign ($).Round your answer to 2 decimal places. (e.g., 32.16)) |
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| Market value | $ |
| (b) | If the company decides instead to make the bonds callable in one year, what coupon will be demanded by the bondholders for the bonds to sell at par? Assume that the bonds will be called if interest rates rise and that the call premium is equal to the annual coupon.(Do not include the percent sign (%). Round your answer to 2 decimal places. (e.g., 32.16)) |
| Coupon rate | % |
| (c) | What will be the value of the call provision to the company?(Do not include the dollar sign ($).Round your answer to 2 decimal places. (e.g., 32.16)) |
| Value | $ |
3.
| Money, Inc., has no debt outstanding and a total market value of $165,600. Earnings before interest and taxes, EBIT, are projected to be $23,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 33 percent higher. If there is a recession, then EBIT will be 57 percent lower. Money is considering a $64,800 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 4,600 shares outstanding. Assume Money has a tax rate of 40 percent. |
| Required: |
| (a) | Calculate earnings per share, EPS, under each of the three economic scenarios assuming the company goes through with the recapitalization. Also calculate the percentage changes in EPS when the economy expands or enters a recession.(Do not include the dollar signs ($). Negative amount should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16)) |
| Recession | Normal | Expansion | |||||
| EPS | $ | $ | $ | ||||
| %?EPS | — | ||||||
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| (b) | Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in EPS when the economy expands or enters a recession assuming that Money goes through with recapitalization.(Do not include the dollar signs ($). Negative amount should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16)) |
| Recession | Normal | Expansion | |||||
| EPS | $ | $ | $ | ||||
| %?EPS | — | ||||||
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8.
| Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all-equity firm, has 9,800 shares of stock outstanding, currently worth $18 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta’s debt is $50,000, and its cost of debt is 15 percent. Each firm is expected to have earnings before interest of $45,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 15 percent per year. |
| Requirement 1: |
| What is the value of Alpha Corporation?(Do not include the dollar sign ($).) |
| Value of Alpha | $ |
| Requirement 2: |
| What is the value of Beta Corporation?(Do not include the dollar sign ($).) |
| Value of Beta | $ |
| Requirement 3: |
| What is the market value of Beta Corporation’s equity?(Do not include the dollar sign ($).) |
| Value of Beta’s equity | $ |
| Requirement 4: |
| How much will it cost to purchase 21 percent of each firm’s equity?(Do not include the dollar signs ($).) |
| Cost for Alpha | $ |
| Cost for Beta | $ |
| Requirement 5: |
| Assuming each firm meets its earnings estimates, what will be the dollar return to each position in requirement 4 over the next year?(Do not include the dollar signs ($). Round your answers to the nearest whole dollar amount. (e.g., 32)) |
| Return on Alpha | $ |
| Return on Beta | $ |
9.
| Williamson, Inc., has a debt–equity ratio of 2.52. The firm’s weighted average cost of capital is 14.5 percent, and its pretax cost of debt is 9.4 percent. Williamson is subject to a corporate tax rate of 40 percent. |
| Requirement 1: |
| What is Williamson’s cost of equity capital?(Do not include the percent sign (%). Round your answer to 2 decimal places. (e.g., 32.16)) |
| Cost of equity | % |
| Requirement 2: |
| What is Williamson’s unlevered cost of equity capital?(Do not include the percent sign (%). Round your answer to 2 decimal places. (e.g., 32.16)) |
| Unlevered cost of equity | % |
| Requirement 3: | |
| (a) | What would Williamson’s weighted average cost of capital be if the firm’s debt–equity ratio were 0.66?(Do not include the percent sign (%). Round your answer to 2 decimal places. (e.g., 32.16)) |
| Weighted average cost | % |
| (b) | What would Williamson’s weighted average cost of capital be if the firm’s debt–equity ratio were 1.48?(Do not include the percent sign (%). Round your answer to 2 decimal places. (e.g., 32.16)) |
| Weighted average cost | % |
10.
| Tom Scott is the owner, president, and primary salesperson for Scott Manufacturing. Because of this, the company’s profits are driven by the amount of work Tom does. If he works 40 hours each week, the company’s EBIT will be $411,000 per year; if he works a 50-hour week, the company’s EBIT will be $511,000 per year. The company is currently worth $2.51 million. The company needs a cash infusion of $1.28 million, and it can issue equity or issue debt with an interest rate of 8.5 percent. Assume there are no corporate taxes. |
| Requirement 1: |
| What are the cash flows to Tom under each scenario?(Do not include the dollar signs ($). Round your answers to the nearest whole dollar amount. (e.g., 32)) |
| Debt issue | Equity issue | ||
| 40 hour week cash flow | $ | $ | |
| 50 hour week cash flow | $ | $ | |
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| Requirement 2: |
| Under which form of financing is Tom likely to work harder? |
10.
| Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies’ economists agree that the probability of the continuation of the current expansion is 85 percent for the next year, and the probability of a recession is 15 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $2.41 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $915,000. Steinberg’s debt obligation requires the firm to pay $805,000 at the end of the year. Dietrich’s debt obligation requires the firm to pay $1.18 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 13 percent. |
| Requirement 1: |
| What is the value today of Steinberg’s debt and equity? What about that for Dietrich’s?(Do not include the dollar signs ($). Enter your answers in dollars, not millions of dollars. (e.g., 1,234,567)) |
| Debt | Equity | ||
| Steinberg | $ | $ | |
| Dietrich | $ | $ | |
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| Requirement 2: |
| Steinberg’s CEO recently stated that Steinberg’s value should be higher than Dietrich’s because the firm has less debt and therefore less bankruptcy risk. Do you agree or disagree with this statement? |
12.
| Zoso is a rental car company that is trying to determine whether to add 30 cars to its fleet. The company fully depreciates all its rental cars over five years using the straight-line method. The new cars are expected to generate $148,000 per year in earnings before taxes and depreciation for five years. The company is entirely financed by equity and has a 32 percent tax rate. The required return on the company’s unlevered equity is 13.9 percent, and the new fleet will not change the risk of the company. |
| Requirement 1: |
| What is the maximum price that the company should be willing to pay for the new fleet of cars if it remains an all-equity company?(Do not include the dollar sign ($). Round your answer to 2 decimal places. (e.g., 32.16)) |
| Maximum price | $ |
| Requirement 2: |
| Suppose the company can purchase the fleet of cars for $378,000. Additionally, assume the company can issue $246,000 of five-year, 7.2 percent debt to finance the project. All principal will be repaid in one balloon payment at the end of the fifth year. What is the adjusted present value (APV) of the project?(Do not include the dollar sign ($). Round your answer to 2 decimal places. (e.g., 32.16)) |
| Adjusted present value | $ |
13.
| North Pole Fishing Equipment Corporation and South Pole Fishing Equipment Corporation would have identical equity betas of 1.7 if both were all equity financed. The market value information for each company is shown here: |
| North Pole | South Pole | |||||||
| Debt | $ | 4,700,000 | $ | 5,600,000 | ||||
| Equity | $ | 5,600,000 | $ | 4,700,000 | ||||
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| The expected return on the market portfolio is 13.9 percent, and the risk-free rate is 5.4 percent. Both companies are subject to a corporate tax rate of 30 percent. Assume the beta of debt is zero. |
| Requirement 1: |
| What is the equity beta of each of the two companies?(Round your answers to 2 decimal places. (e.g., 32.16)) |
| Equity beta | |
| North Pole | |
| South Pole | |
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| Requirement 2: |
| What is the required rate of return on each of the two companies’ equity?(Do not include the percent signs (%). Round your answers to 2 decimal places. (e.g., 32.16)) |
| Rate of return | |
| North Pole | % |
| South Pole | % |
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14.
| Bolero, Inc., has compiled the following information on its financing costs: |
| Type of Financing | Book Value | Market Value | Cost | |||||||||
| Short-term debt | $ | 3,000,000 | $ | 3,000,000 | 3.7 | % | ||||||
| Long-term debt | 13,000,000 | 15,000,000 | 5.9 | % | ||||||||
| Common stock | 7,000,000 | 28,000,000 | 14.5 | % | ||||||||
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| Total | $ | 23,000,000 | $ | 46,000,000 | ||||||||
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| The company is in the 40 percent tax bracket and has a target debt–equity ratio of 55 percent. The target short-term debt/long-term debt ratio is 15 percent. |
| Requirement 1: |
| What is the company’s weighted average cost of capital using book value weights?(Do not include the percent sign (%). Round your answer to 2 decimal places. (e.g., 32.16)) |
| Weighted average cost of capital | % |
| Requirement 2: |
| What is the company’s weighted average cost of capital using market value weights?(Do not include the percent sign (%). Round your answer to 2 decimal places. (e.g., 32.16)) |
| Weighted average cost of capital | % |
| Requirement 3: |
| What is the company’s weighted average cost of capital using target capital structure weights?(Do not include the percent sign (%). Round your answer to 2 decimal places. (e.g., 32.16)) |
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| Weighted average cost of capital | % |
| Requirement 4: |
| Which is the correct WACC to use for project evaluation? |
15.
| Seger, Inc., is an unlevered firm with expected annual earnings before taxes of $32 million in perpetuity. The current required return on the firm’s equity is 20 percent, and the firm distributes all of its earnings as dividends at the end of each year. The company has 1.6 million shares of common stock outstanding and is subject to a corporate tax rate of 40 percent. The firm is planning a recapitalization under which it will issue $35 million of perpetual 10 percent debt and use the proceeds to buy back shares. |
| Requirement 1: |
| Calculate the value of the company before the recapitalization plan is announced. What is the value of equity before the announcement? What is the price per share?(Do not include the dollar signs ($). Enter your answer in dollars, not millions of dollars (e.g., 1,234,567). Round your price per share to 2 decimal places. (e.g., 32.16)) |
| Value of equity | $ |
| Price per share | $ |
| Requirement 2: |
| Use the APV method to calculate the company value after the recapitalization plan is announced. What is the value of equity after the announcement? What is the price per share?(Do not include the dollar signs ($). Enter your answer in dollars, not millions of dollars (e.g., 1,234,567). Round your new share price to 2 decimal places. (e.g., 32.16)) |
| Value of equity | $ |
| New share price | $ |
| Requirement 3: |
| How many shares will be repurchased? What is the value of equity after the repurchase has been completed? What is the price per share?(Do not include the dollar signs ($). Round your shares repurchased to the nearest whole number (e.g., 32). Enter your answer in dollars, not millions of dollars (e.g., 1,234,567). Round your new share price to 2 decimal places. (e.g., 32.16)) |
| Shares repurchased | |
| Value of equity | $ |
| New share price | $ |
| Requirement 4: |
| Use the flow to equity method to calculate the value of the company’s equity after the recapitalization.(Do not include the dollar sign ($). Enter your answer in dollars, not millions of dollars. (e.g., 1,234,567)) |
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| Value of equity | $ |
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