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##### Final Exam Question Pool - Spring 2012 1) What ar...

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Final Exam Question Pool - Spring 2012 1) What are the expected return, standard deviation, and beta of a portfolio comprised of $1,500 invested in stock A, $4,500 in stock B and $4,000 in stock C in the below economy? The risk-free rate and the market riskpremium are 4% and 6%, respectively. State of Probability of Returns if State Occurs Economy State of Economy Stock A Stock B Stock C Boom 15% 21% 12% 16% Normal 80% 11% 9% 12% Recession 5% -18% 2% -22% 2) There are two stocks in the market, stock A and B. The price of stock A today is $50. The price of stock A next year will be $40 if the economy is in a recession, $55 if the economy is normal, and $60 if the economy is expanding. The probabilities of recession, normal times, and expansion are 0.1, 0.8, and 0.1, respectively. Stock A pays no dividends and has a correlation coefficient of 0.8 with the market portfolio. Stock B has an expected return of 9%, a standard deviation of 12%, a correlation coefficient with the market portfolio of 0.2, and a correlation coefficient with stock A of 0.6. The market portfolio has a standard deviation of 10%. a. If you are a typical investor with a well-diversified portfolio, which stock would you prefer? Why? b. What are the expected return, standard deviation, and beta of a portfolio made up of 70% A and 30% B? 3) The characteristics of stock A and B, which are the only investable assets in any economy, are given as follows: Stock Expected Return Standard Deviation A 10% 5% B 15% 10% Correlation Coefficient (A,B) = -1 Suppose that it is possible to lend and borrow at the risk-free rate. What must be the value of the risk-free rate? Hint: Any asset without risk should earn the risk-free rate of return. 4) FCOJ, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 40 percent debt. Currently, there are 5,800 shares outstanding and the price per share is $66. EBIT is expected to remain at $21,998 per year forever. The interest rate on new debt is 11 percent, and there are no taxes. a. Melanie, a shareholder of the firm, owns 250 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent? b. What will Melanie?s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 250 of her shares. c. Suppose FCOJ does convert, but Melanie prefers the current all-equity capital structure. Show how she could unlever her shares of stock to recreate the original capital structure. 5) Consider a project to produce solar water heaters. It requires a $10,000,000 investment and offers a level after-tax cash flow of $1,690,000 per year for 10 years. The opportunity cost of capital is 11.25%, which reflects the project?s business risk. a. Suppose the project is financed with $7,000,000 of debt and $3,000,000 of equity. The interest rate is 7.25% and the marginal tax rate is 34%. The debt will be paid off in equal annual installments over the project?s 10-year life. Calculate the project?s APV. b. If the firm incurs issue costs of $500,000 to raise the $3,000,000 of required equity. Calculate the project?s APV. 6) Digital Organics will invest $0.90 million and expects after-tax returns of $500,000 in the next two years. The project will last for two years only. The appropriate cost of capital is 12% with all-equity financing, the borrowing rate is 8%, and DO will borrow $200,000 against the project. This debt must be repaid in two equal installments. Assume debt tax shields have a net value of $0.30 per dollar of interest paid. Calculate the project?s APV. 7) Sultan?s Kitchen offers authentic Ottoman and Turkish cuisine in Manhattan. The company has been very profitable and the owners are planning to expand to four major metropolitan areas, including Boston, Chicago, Los Angeles, and Dallas. The following BOOK-VALUE balance sheet is given for Sultan?s Kitchen. Book Value Balance Sheet (in thousand $) Assets Liabilities ____________________________________________________________________________________ Cash & Short-Term Securities 3,000 Bonds 20,000 (8% annual coupon, 10yr, Face Value: 1000, Market Value: 877.108) (# of bonds outstanding: 20) Accounts Receivable 4,000 Preferred Stock 2,000 (# of shrs outstanding: 200) Restaurants & Equipment 35,000 Common Stock 1,000 (# of shrs outstanding: 1000) Additional Paid-in Capital 9,000 Retained Earnings 10,000 The expansion is going to require an initial investment of $50 million and it will increase after-tax cash flows by $10 million for the next 10 years. The preferred stock of the company is trading at $16/share and pays an annual dividend of $1.2. The common stock sells for $20/share. The 3-month T-Bill rate is 4% and the rate of return on the S&P 500 index is 12%. The company has an equity-beta of 1.5. The corporate tax rate is 40%. a. What is the WACC of Sultan?s Kitchen? b. Should Sultan?s Kitchen expand its business? Support your answer with appropriate calculations. c. Sultan?s Kitchen is evaluating a pilot project at its original Manhattan location. Under consideration is the idea of purchasing the adjacent store and turning it into an adjoint kindergarten/recreational area where the restaurant is to offer child care services for restaurant patrons? kids. An initial study reveals that the existing kindergartens in Manhattan are all-equity financed with betas of 0.5. The project needs an initial investment of $800,000 but it will add $125,000 to annual after-tax cash flows for the next 10 years. Should Sultan?s Kitchen offer child-care services to its customers? 8) Frodo, Inc. is an all-equity firm with 1,000 shares of common stock outstanding. Investors require a 20 percent return on Frodo?s unlevered equity (equivalently RA). The company distributes all of its earnings to equity holders as dividends at the end of each year. Frodo estimates that its annual earnings before interest and taxes (EBIT) will be $1,000, $2,000, or $4,200 with probabilities of 0.1, 0.4, and 0.5, respectively. The firm?s expectations about earnings will be unchanged in perpetuity. There are no corporate or personal taxes. a.What is the value of the firm? b. Suppose Frodo issues $7,500 of debt at an interest rate of 10 percent and uses the proceeds to repurchase 500 shares of common stock. 1.What is the new value of the firm? 2.What is the new value of the firm?s equity? 3. What is the required return on the firm?s levered equity? 4.What is the firm?s weighted average cost of capital? c. Suppose that Frodo?s earnings are subject to a corporate tax rate of 40 percent. 1.Will the presence of corporate taxes increase or decrease the value of the firm? Why? 2.What is the value of the firm? 9) The Holland Company expects perpetual earnings before interest and taxes (EBIT) of $4 million per year. The firm?s after-tax, all-equity discount rate (equivalently RA) is 15 percent. Holland is subject to a corporate tax rate of 35 percent. The pretax cost of the firm?s debt capital is 10 percent per annum, and the firm has $10 million of debt in its capital structure. a. What is Holland?s value? b. What is Holland?s cost of equity (RE)? c. What is Holland?s weighted average cost of capital (RWACC)? 10) Locomotive Corporation is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firm?s debt-to-equity ratio is expected to rise from 40 percent to 50 percent. The firm currently has $7.5 million worth of debt outstanding. The cost of this debt is 10%. Locomotive expects to earn $3.75 million per year in perpetuity. Locomotive pays no taxes. a. What is the market value of Locomotive Corporation before and after the repurchase announcement? b. What is the expected return on the firm?s equity (rE) before the announcement of the stock repurchase plan? c. What is the expected return of equity of an otherwise identical all-equity firm (rA)? d. What is the expected return on the firm?s equity (rE) after the announcement of the stock repurchase plan? 11) Clarix Inc. is a publicly traded company that operates in two businesses ? it generates 60% of its value from entertainment and 40% from electronics. The company has 100 million shares trading at $ 8/share, has $ 400 million (market and book value) in interest bearing debt and lease commitments of $ 80 million each year for the next 6 years. The current levered beta for the firm is 1.15 and the current bond rating for the firm is BBB, which corresponds to a default spread of 1.5% (Default spread is the premium over the risk-free rate to compensate for default risk of the firm). The US-treasury bill rate is 3.5%, the market risk premium is 5% and the marginal tax rate is 40%. a. Estimate the current cost of capital for the firm b. Now assume that the firm plans to sell its electronics business at fair value and use 75% the proceeds to pay a special dividend to equity investors and 25% of the proceeds to retire interest bearing debt. If the unlevered beta of the electronics business is 0.90 and this transaction will lower the rating to BB (with a default spread of 3%), estimate the cost of capital after the transaction. 12) Prolox Inc. is a pharmaceutical company with 100 million shares trading at $10/share and debt outstanding of $ 250 million. The firm has a levered beta of 1.00 and a pre-tax cost of debt of 4.5%. The risk-free rate is 3.5%, the marginal tax rate is 40% and the cost of equity is 8.5%. a. Estimate the current cost of capital for the firm. b. Now assume that the firm plans to borrow $ 500 million and buy back stock. If this will triple the default spread on the debt (both new and existing), estimate the new cost of capital for the firm after the recapitalization (Default spread is the premium over the risk-free rate to compensate for default risk of the firm). c. Now assume that the firm does buy back stock with the $ 500 million at a purchase price of $ 11/share. Estimate the value per share for the remaining shareholders in the company. (You can assume no growth in perpetuity) 13) CIQ Inc. is a company that provides information services to financial service companies. The company currently has 150 million shares, trading at $ 10 a share, and $ 500 million in debt (book and market). The firm currently has a beta (levered) of 1.20 and a pre-tax cost of debt of 6%; the marginal tax rate is 40%; the risk free rate is 4% and the market risk premium is 5%. The firm is considering borrowing $ 500 million and buying back stock; it believes that doing so will lower its cost of capital to 8%. (You can assume no growth in the savings in perpetuity) a. Assuming that the firm can buy back stock at $10.25/share, estimate the increase in value per share for the remaining shares. b. Now assume that you do not know what the price per share will be on the stock buyback. How much would the price per share on the buyback have to be for the value per share on the remaining shares to remain unchanged at $10/share? 14) You have been asked by Med Parts Inc., a medical device maker, for advice on whether they are using the right mix of debt and equity to fund their operations. The firm has 120 million shares trading at $ 10 a share and $ 300 million in outstanding debt. The current levered beta for the firm is 1.10 and the pre-tax cost of borrowing is 6%. The marginal tax rate is 40%, the risk-free rate is 5% and the equity risk premium is 4%. a. Estimate the current cost of capital for the firm. b. If the market is valuing the firm correctly today and the expected free cash flow to the firm next year is $ 80 million, estimate the implied growth rate in this cash flow in perpetuity (given the cost of capital that you estimated in part a. c. You estimate the optimal debt ratio for the firm to be 40% and believe that the cost of capital will drop to 8%, if you move to the optimal by borrowing money and buying back shares. If you buy back the shares at $10.25/share, estimate the increase in value per share for the remaining shares. 15) A computer costs $500,000 and is depreciated straight-line over 5 years to a salvage value of zero. The user wishes to lease the computer by making 6 annual lease payments, the first of which is due immediately. If taxes are paid without delay and the rate of interest is 10%, what is the minimum acceptable lease payment for a lessor who pays tax at 35%? 16) Your firm is considering leasing a new computer. The lease lasts for 9 years. The lease calls for 10 payments of $1,000 per year with the first payment occurring immediately. The computer would cost $8,100 to buy and would be depreciated using the straight-line method to zero salvage over 9 years. The firm can borrow at a rate of 8%. The corporate tax rate is 30%. What is the NPV of the lease? 17) The current price of Tremblant?s stock is $108. During each six-month period it will either rise by 11.90% or fall by 10.80%. The interest rate is 5% per six-month period. a. Calculate the value of a one-year European put option on Mont Tremblant?s stock with an exercise price of $112.00. b. Calculate the value of a one-year American put option on Mont Tremblant?s stock with an exercise price of $112.00. 18) A stock is currently selling for $46. Over the next two periods, the stock will either move up by 35% or down by 21%. If the risk-free rate of interest is 3.2 percent per period, what is the value of a call option with a strike price of $62? 19) In January 2009, a one-year call on the stock of Amazon.com, with an exercise price of $53, sold for $27.55. The stock price was $63. The risk-free interest rate was 4.50%. (Note: Amazon does not pay a dividend.) Assume that the Amazon options are European options. How much would you be willing to pay for a put on Amazon stock with the same maturity and exercise price? 20) A condor is a strategy that involves four options with the same expiration date, all with different strike prices. A long condor position involves buying a call with a low strike price X1, selling a call with a somewhat higher strike price X2, selling another call with yet a higher strike price X3, and buying a call with the highest strike price X4. (X1 < X2 < X3 < X4). Write the payoff schedule and draw the payoff & profit diagrams of a condor and discuss when you would use such a position. 21) A butterfly spread involves buying a call option with exercise price X1, another call option with exercise price X3 and selling two calls with exercise price X2, where X2=(X1+X3)/2 and X1 Interest Coverage Ratio <= Spread over T-bond AAA 9.65 ? 0.30% AA 6.85 9.35 0.70% A+ 5.65 6.849999 1.00% A 4.49 5.649999 1.25% A- 3.29 4.4899999 1.50% BBB 2.76 3.2899999 2.00% BB 2.17 2.7599999 2.50% B+ 1.87 2.1699999 3.00% B 1.57 1.8699999 4.00% B- 1.27 1.5699999 5.00% CCC 0.87 1.2699999 6.00% CC 0.67 0.8699999 7.50% C 0.25 0.6699999 9.00% D -100000 0.2499999 12.00% The treasury bill rate is 3.00% and the treasury bond rate is 6.25%. a. What is the current cost of equity? b. What is your best estimate of the current after-tax cost of debt? (The company is not rated currently) c. What is the current cost of capital? Boston Turkey is contemplating borrowing $500,000 to repurchase stock. If it does so, its rating will drop to A-. a. If it does so, what will the new cost of equity be? b. How much will the stock price change if it borrows $500,000 and buys back stock? Assets Liabilities Property, Plant & Equipment $ 1,500,000 Accounts Payable $ 500,000 Land & Buildings $ 500,000 Long Term Debt $ 1,000,000 Current Assets $ 1,000,000 Equity $ 1,500,000 Total $ 3,000,000 Total $ 3,000,000 31) VRC Inc., a privately-owned business in several business lines, wants to estimate a cost of equity for itself as a business. The company provides you with the following information on the businesses it operates in, the operating income it has in each business and the betas of comparable firms in each business line. Business Line Operating Income Comparable Firms Beta D/E Ratio Technology $ 50 million 1.60 10% Auto Parts $ 40 million 1.20 30% Financial Services $ 60 million 1.15 100% Assuming that the tax rate for all firms is 40%, that the operating income is proportional to divisional value and that VRC has a debt to capital ratio of 40%, estimate the equity beta for VRC. 32) You have been asked to assess the cost of equity for Transverse International, a publicly traded firm that operates in the entertainment and travel businesses. You have collected the following information on the value generated by Transverse in each of the businesses and relevant sector information: Business Estimated Value Averages for the Sector Regression beta Unlevered Beta Entertainment $ 1.5 billion 1.50 1.20 Travel $ 1 billion 2.00 0.80 Transverse has a book value for equity of $ 500 million and a book value of debt of $ 500 million as well; the latter is also the market value for debt. The effective tax rate is 30% and the marginal tax rate is 40%. a. Estimate the unlevered beta for Transverse International. b. Estimate the levered beta for Transverse International. c. Assume that Transverse plans to borrow $ 1 billion to use for two purposes: $ 500 million will be used to buy back stock and $ 500 million to expand the travel business. Estimate the levered beta after the transaction. 33) PetSmart Inc. is a publicly traded company involved in selling pet food and accessories. The firm has 15 million shares outstanding, trading at $ 10 a share; it has $ 50 million in 10-year bonds outstanding and interest expenses on the debt amounted to $ 2 million. The firm currently is rated A with a cost of debt of 5% and has a levered beta of 1.56. The risk-free rate is 4.5% and the market risk premium is 4%. The corporate marginal tax rate is 40%. a. Estimate the current cost of capital for PetSmart. b. PetSmart announces that it will be borrowing $ 50 million and buying back stock at $10.75 a share. This will lower the rating to BB, with a pre-tax cost of debt of 7%. Assuming that all of the existing debt gets refinanced at this new rate, estimate the value per share after this transaction. (You can assume a growth rate of 3% in perpetuity.) 34) Information on Janicek Power Co., is shown below. What is the firm?s WACC if the tax rate is 34%? ? Debt: 9,600 units of 9.1 percent coupon bonds outstanding, $1,000 par value, 24 years to maturity, selling for 98.5 percent of par; the bonds make semiannual payments. ? Common stock: 221,000 shares outstanding, selling for $84.1 per share; beta is 1.26. ? Preferred stock: 13,100 shares of 5.80 percent preferred stock outstanding, currently selling for $96.9 per share. ? Market: 7.05 percent market risk premium and 4.85 percent risk-free rate. 35) Quartz Corporation is a relatively new firm. Quartz has experienced enough losses during its early years to provide it with at least eight years of tax loss carry-forwards. Thus, Quartz?s effective tax rate is zero. Quartz plans to lease equipment from New Leasing Company. The term of the lease is five years. The purchase cost of the equipment is $764,000 and will be depreciated to a salvage value of zero. New Leasing Company is in the 30 percent tax bracket. There are no transaction costs to the lease. Each firm can borrow at 4 percent. a. Is a lease possible between these two parties? b. If so, what would be the most fair lease payment? 36) Blue Angel, Inc., a private firm in the holiday gift industry, is considering a new project. The company currently has a target debt?equity ratio of .38, but the industry target debt?equity ratio is .28 The industry average beta is 1.5. The market risk premium is 5 percent, and the risk-free rate is 5.7 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 35 percent. The project requires an initial outlay of $460,000 and is expected to result in a $88,000 cash inflow at the end of the first year. The project will be financed at Blue Angel?s target debt?equity ratio. Annual cash flows from the project will grow at a constant rate of 6.7 percent until the end of the fifth year and remain constant forever thereafter. Should Blue Angel invest in the project? 37) Neon Corporation?s stock returns have a covariance with the market portfolio of .041. The standard deviation of the returns on the market portfolio is 19 percent, and the expected market risk premium is 7.4 percent. The company has bonds outstanding with a total market value of $38 million and a yield to maturity of 11 percent. The company also has 4 million shares of common stock outstanding, each selling for $20. The company?s CEO considers the firm?s current debt?equity ratio optimal. The corporate tax rate is 37 percent, and Treasury bills currently yield 4.2 percent. The company is considering the purchase of additional equipment that would cost $47 million. The expected unlevered cash flows from the equipment are $15 million per year for five years. Purchasing the equipment will not change the risk level of the firm. Should Neon purchase the equipment? 38) Wolfson Corporation has decided to purchase a new machine that costs $4.9 million. The machine will be depreciated on a straight-line basis and will be worthless after four years. The corporate tax rate is 40 percent. The Sur Bank has offered Wolfson a four-year loan for $4.9 million. The repayment schedule is four yearly principal repayments of $1,225,000 and an interest charge of 9 percent on the outstanding balance of the loan at the beginning of each year. Both principal repayments and interest are due at the end of each year. Cal Leasing Corporation offers to lease the same machine to Wolfson. Lease payments of $1.42 million per year are due at the beginning of each of the four years of the lease. What is the annual lease payment that will make Wolfson indifferent to whether it leases the machine or purchases it? 39) Andersen Enterprises manufactures window furnishings and also builds new houses; the window furnishings business accounted for 40% of the total revenues of $ 1 billion in the most recent year. The firm is publicly traded and has 15 million shares outstanding, trading at $ 40 a share and the market value of debt outstanding is $ 400 million. The company is rated BBB, and the typical default spread for BBB rated bonds is 1.8% over the riskless rate. You have obtained the unlevered betas and average firm value/sales ratios for the two businesses that Andersen operates in below by looking at comparable firms: Business Unlevered beta Firm Value/Sales Ratio House furnishing 1.30 1.6 Construction services 0.90 0.6 Andersen?s tax rate is 40%. The riskless rate is 5% and the market risk premium is 4%. a. Estimate the levered beta for Andersen. b. Estimate the cost of capital for Andersen. c. Now assume that Andersen is considering a plan to borrow $ 200 million and expand its construction business. Assuming that this plan goes through, estimate the new levered beta for Andersen. 40) You have been asked to assess the cost of capital for Mylar Telecommunications, a firm that has recently gone through financial turmoil. The firm has 100 million shares outstanding, trading at $ 10 per share, and about $ 9 billion in debt (in market value terms). The company is in two businesses ? telecommunications equipment and internet services. You have collected the following information on the businesses: Business Estimated Value Unlevered beta from comparables Telecomm Equipment $ 6 billion 0.90 Internet Services $ 4 billion 1.40 The average coupon rate on the debt is 10% but the firm has been downgraded to a CC rating, and CC rated bonds trade at a default spread of 12% over the treasury bond rate (which is currently 5%). The firm has been steadily losing money and has accumulated net operating losses of more than $ 4 billion; the firm does not expect to pay taxes for the next 4 years. (The market risk premium is 4% and the marginal tax rate for all firms is 40%) a. Estimate the levered beta for Mylar for next year. b. Estimate the cost of capital for Mylar for the next year. c. Now assume that Mylar could sell half of its internet business for fair market value ($2 billion) and use the cash to pay off debt. Estimate the new levered beta of the firm. 41) Novacell Inc. is a manufacturer of solar panels that is considering moving from its existing policy of not borrowing money. The firm has 4 million shares outstanding, trading at $ 25 a share, no cash holdings and a beta of 1.20. The risk-free rate is 5%, the equity risk premium is 4% and the corporate tax rate is 40%. a. Estimate the current cost of capital for the firm. b. Assume that the firm can borrow $ 25 million at a pre-tax rate of 7% and buy back shares.. Assuming that the firm is growing 3% a year in perpetuity and that investors are rational, estimate the change in value per share after the buyback. c. Assume that instead of buying back shares, the firm had borrowed $25 million and invested the money in expanding its existing business. If the expansion has a net present value of $ 5 million, estimate the change in value per share after the transaction. 42) You have been asked to estimate the cost of capital for Simtel Enterprises, a firm with operations in different businesses. You are given the breakdown of the three businesses that Simtel is in below: Business Estimated Value Average Unlevered beta: Comparables Telecomm Services $ 2.0 billion 1.00 Computer Software $ 1.0 billion 1.25 Real Estate Management $ 1.0 billion 0.60 Simtel has 100 million shares outstanding, trading at $ 20 a shares; its remaining capital is in the form of corporate bonds with a BB rating, carrying a default spread of 4% over the risk-free rate. Simtel?s marginal tax rate is 40%. The long term treasury bond rate is 6% and the market risk premium is 4%. a. Estimate the cost of capital for Simtel. b. Now assume that Simtel sells its real estate services division at its estimated value and uses the funds to retire debt. This will cause its rating to rise to A and the default spread on its bonds to drop to 1.5%. Estimate the new cost of capital for Simtel. 43) Jackson-Presley Inc. produces and sells musical CDs and cassettes and it is also involved in promoting concerts. The company?s financial statements for the last two years are given below. Last Year Current Year Revenues $ 100 million $150 million - Cost of Goods Sold $ 40 million $ 60 million - Depreciation & Amortization $ 10 million $ 13 million Earnings before interest and taxes $ 50 million $ 85 million Interest Expenses $ 0 $ 5 million Taxable Income $ 50 million $ 80 million Taxes $ 20 million $ 32 million Net Income $ 30 million $ 48 million Assets Liabilities Property, Plant & Equipment $ 100 million Current Liabilities $ 20 million Land and Buildings $ 50 million Debt $ 60 million Current Assets $ 50 million Equity $120 million Total $ 200 million Total $200 million Jackson-Presley's stock has been listed on the NASDAQ for the last two years and is trading at twice the book value (of equity). There are 12 million shares outstanding. Jackson-Presley derives 75% of its total market value from its record/CD business and 25% from the concert business. While the price data on the company is insufficient to estimate a beta, the betas of comparable firms in these businesses is as follows ? Business Average Beta Average D/E Ratio Record/CD Business 1.15 50.00% Concert Business 1.20 10.00% You can assume that these companies have 40% tax rates. The debt is composed of ten-year bonds, and is rated A (Typical A rated bonds are yielding 10% currently in the market). The current treasury bond rate is 8.00%. a. Estimate the market value of the debt. b. Estimate the current cost of equity. c. Estimate the current weighted average cost of capital. 44) Loman Enterprises is a public traded company, with 60 million shares outstanding, trading at $10/share and $ 400 million in debt outstanding (book and market value). The firm currently has a pre-tax cost of debt of 8% and a cost of capital of 9.72%. The risk-free rate is 3%, the equity risk premium is 5% and the marginal tax rate is 40%. Shaken by the financial crisis, the firm is planning on issuing new shares and retiring all of its debt. If it does so, what will its cost of capital be after the transaction? 45) Beltran Enterprises is a publicly traded transportation firm with 80 million shares outstanding, trading at $25 a share and $ 500 million in debt. The firm has $120 million in operating income (EBIT), its current cost of equity is 10% and its current rating is A (with a default spread of 2% over the risk-free rate). The current riskfree rate is 4%, the marginal tax rate is 40% and the equity risk premium is 5%. a. Estimate the current cost of capital for the firm. b. Now assume that the firm is considering tripling its dollar debt and buying back stock. If this action will lower the bond rating to B and increase the default spread to 6%, estimate the interest expenses at the new debt level and the tax rate to use to compute the after-tax cost of debt. c. If the firm does triple its dollar debt and buys back stock, estimate the new cost of capital for the firm. 46) Delgado Enterprises is an auto parts company that has accumulated considerable debt. The firm has 50 million shares, trading at $ 8 a share, and $ 600 million in debt outstanding (in market value terms). The current levered beta for the firm is 2.28 and the firm has a BB rating, with a default spread of 6% over the risk-free rate. The risk-free rate is 4% and the equity risk premium is 6%. The marginal tax rate is 40%. a. Estimate the current cost of capital for the firm. b. Now assume that the firm is considering issuing equity, with the intent of halving its debt to capital ratio. If this action will improve the rating of the firm to A, with a default spread of 2.5% over the risk free rate, estimate the new cost of capital for the firm. 47) You are assessing the optimal capital structure for Totem Holdings, a large publicly traded chemical company with 100 million shares trading at $ 30 per share and $ 1 billion in debt outstanding. The firm currently has a pre-tax cost of debt of 6% and you have correctly estimated the current cost of capital to be 9%. The firm is planning to borrow an additional $ 2 billion (which will push up the pre-tax cost of debt to 7%) and use the proceeds to buy back $ 1 billion in stock and invest $1 billion in its existing business. The firm?s tax rate is 40%, the current risk-free rate is 5% and the market risk premium is 4%. a. Estimate the new cost of equity for this firm after the transaction. b. Estimate the new cost of capital after the transaction. c. Estimate the change in the value per share if the firm moves to its optimal by buying back shares at $ 33 per share. (You can ignore the NPV of the investment in the existing business) 48) Seger, Inc., is an unlevered firm with expected annual earnings before taxes of $34 million in perpetuity. The current required return on the firm?s equity is 10 percent, and the firm distributes all of its earnings as dividends at the end of each year. The company has 1.7 million shares of common stock outstanding and is subject to a corporate tax rate of 45 percent. The firm is planning a recapitalization under which it will issue $37 million of perpetual 8 percent debt and use the proceeds to buy back shares. a. 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? b. 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? c. Use the flow to equity method to calculate the value of the company?s equity after the recapitalization. 49) Liberty Media is a telecom company that is coming off several years of a borrowing binge. The firm currently has $ 800 million in debt outstanding, 10 million shares trading at $ 20 a share and faces a cost of capital of 12%. The firm is considering issuing $ 300 million of new equity and repaying debt and believes that doing so will lower the cost of capital to 10%. The firm?s operations are in stable growth, growing at 4% a year. a. Estimate the increase in firm value from this transaction. b. Assuming that Liberty Media issued 20 million shares, in a private placement, to raise the $ 300 million (to retire debt), estimate the value of equity per share after the transaction. 50) SDL is a firm manufacturing perfumes and other cosmetics and it sells its products worldwide. The f

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