98 Part IV

2010 6 21

MM Propositions

15 #23452

Locomotive Corporation is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firm's debt-equity ratio is expected to rise from 40 percent to 50 percent. The firm currently has CAD 7.5 million worth of debt outstanding. The cost of this debt is 10 percent per year. Locomotive expects to have an EBIT of CAD 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 before the announcement of the stock repurchase plan? c. What is the expected return on the equity of an otherwise identical all-equity firm? d. What is the expected return on the firm's equity after the announcement of the stock repurchase plan? CAD L 40% 50%L $7.5M 10%L EBIT $3.75M (a)L (b)(c) L (d)

VL = VU rS = r0 + B S ( r0 rB ) V = EBIT r0
(a)

VL = VU = $7.5M B S = 0.4 S = B 0.4 = $7.5M 0.4 = VL = S + B =

(b)
rS = (c) r0 = (d) rS = r0 + B S ( r0 rB ) = r0 + 0.5 ( r0 rB )
2010/6/21 Part IV 1/6

EBIT B rB $3.75 $7.5M 10% = = S S

EBIT V

MM with Taxes

15 #25452

Rajan. Inc., has a debt-equity ratio of 2.5. The firm's weighted average cost of capital is 15 percent, and its pretax cost of debt is 10 percent. Rajan is subject to a corporate tax rate of 35 percent. a. What is Rajan's cost of equity capital? b. What is Rajan's unlevered cost of equity capital? c. What would Rajan's weighted average cost of capital be if the firm's debt-equity ratio were 0.75? What if it were 1.5?

R B S = 2.5 rWACC = 15% rB = 10% TC = 35% (a) rS (b) r0 (c) B S = 0.75 rWACC B S = 1.5 rWACC

VL = VU + B TC rS = r0 +

B S B rS + rB (1 TC ) ( r0 rB )(1 TC ) rWACC = S S+B S+B

(a)
B S B = 2.5 , S S+B S+B S B rWACC = rS + rB (1 TC ) rS S+B S+B

(b)
rS = r0 + B ( r0 rB )(1 TC ) r0 S

(c)
B ( r0 rB )(1 TC ) rS , B S =0.75 , rS , B S =1.4 S S B rWACC , B S = 0.75 = rS , B S = 0.75 + rB (1 TC ) S+B S+B S B rWACC , B S =1.5 = rS , B S =1.5 + rB (1 TC ) S+B S+B rS = r0 +

2010/6/21

Part IV

2/6

Financial Distress

16 #8485

Good Time Company is a regional chain department store. It will remain in business for one more year. The probability of a boom year is 60 percent and the probability of a recession is 40 percent. It is projected that the company will generate a total cash flow of $250 million in a boom year and $100 million in a recession. The company's required debt payment at the end of the year is $150 million. The market value of the company's outstanding debt is $108.93 million. The company pays no taxes. Assume a discount rate of 10 percent. a. What payoff do bondholders expect to receive in the event of a recession? b. What is the promised return on the company's debt? c. What is the expected return on the company's debt?

G $250M 60%$100M 40%

$150M$108.93MG 10% (a)(b)(c)

(a) min {$150 M , $100M } = $100M (b)

rB =

$150 M 1 $108.93M

(c)
rB =

$150M 60% + $100M 40% 1 $108.93M

2010/6/21

Part IV

3/6

APV

17 #10506

Triad Corporation has established a joint venture with Ottoman Road Construction, Inc., to build a toll road in Adana. The initial investment in paving equipment is TRL 25 million. The equipment will be fully depreciated using the straight-line method over its economic life of five yean. Earnings before interest, taxes, and depreciation collected from the toll road are projected to be TRL 3.4 million per annum for 20 years starting from the end of the first year The corporate tax rate is 35 percent. The required rate of return for the project under all-equity financing is 13 percent. The pretax cost of debt for the joint partnership is 8.5 percent. To encourage investment in the country's infrastructure, the Turkish government will subsidize the project with a TRL 15 million, 15-year loan at an interest rate of 5 percent per year. All principal will be repaid in one balloon payment at the end of year 15. What is the adjusted present value of this project?
TRL

T $25M5
20 $3.4M EBITT 35% 13% 8.5%$15M 5% 15

APV = NPV +

CF = $3.4 M (1 35% )
NPV = $25M + CF PVIFA13%,20

$25M 35% PVIFA13%,5 5 S L = $15M 5% 35% PVIFA13%,15 S D = VL = $15M $15M 5% PVIFA13%,15 $15M PFIV13%,15

APV = NPV + S D + S L + VL

2010/6/21

Part IV

4/6

WACC

17 #13507

Neon Corporation's stock returns have a covariance with the market portfolio of 0.048. The standard deviation of the returns on the market portfolio is 20 percent, and the expected market risk premium is 7.5 percent. The company has bonds outstanding with a total market value of $30 million and a yield to maturity of 8 percent. The company also has 5 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 38 percent, and Treasury bills currently yield 6 percent. The company is considering the purchase of additional equipment that would cost $40 million. The expected unlevered cash flows from the equipment are $13 million per year for five years. Purchasing the equipment will not change the risk level of the firm. a. Use the weighted average cost of capital approach to determine whether Neon should purchase the equipment. b. Suppose the company decides to fund the purchase of the equipment entirely with debt. What is the cost of capital for the project now? Explain.

N N , M = 0.048 M = 20% rM = 7.5%

B = $30 M rB = 8% S = $20 5M TC = 38% rF = 6%

N P0 = $40M CF = $13M 5 (a) (b)

(a)

N ,M = 2 M rM = 7.5% rF = 6% N rS = rF + N ( rM rF ) =
N , M = 0.048 M = 20% N = B = $30M rB = 8% S = $20 5M TC = 38% rS S B rWACC = rS + rB (1 TC ) = S+B S+B rWACC NPV = P0 + CF (1 TC ) PVIVArWACC ,5 =

(b)
B = $30 M + $40M rWACC S B rWACC = rS + rB (1 TC ) = S+B S+B

2010/6/21

Part IV

5/6

Dividends and Firm Value

18 #18545

The net income of Takamaka Cruises is SCR 32,000. The company has 10,000 outstanding shares and a 100 percent payout policy. The expected value of the firm one year from now is SCR 1,545,600. The appropriate discount rate for Takamaka is 12 percent, and the dividend tax rate is zero. a. What is the current value of the firm assuming the current dividend has not yet been paid? b. What is the ex-dividend price of Takamaka's stock if the board follows its current policy? c. At the dividend declaration meeting, several board member claimed that the dividend is too meager and is probably depressing Takamaka's price. They proposed that Takamaka sell enough new shares to finance an SCR 4.25 dividend. i. Comment on the claim that the low dividend is depressing the stock price. Support your argument with calculations. ii. If the proposal is adopted, at what price will the new shares sell? How many will be sold?
SCR

T CF = $32,000 10,000 100%

V1 = $1,545,600 r = 12%

(a) (b) (c)T

D = $4.25

(a)
V0 = V1 PVIFr ,1 =

$1,545,600 = $1,380,000 1 + 12%

V0 = V0 + CF = $1,380,000 + $32,000 = $1, 412,000

(b)

p =

V0 = $138 10,000

(c)
$4.25

$32,000 = $1.05 10,000

p = p $1.05 = $136.95 $1.05 10,000 $10,500 = = = 76.67 n = p p $136.95

2010/6/21

Part IV

6/6