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business
intermediate financial management
Financial Management And Policy 12th Edition James C. Van Horne - Solutions
2.a. (1) Value if unlevered (in thousands):Chapter 9 Theory of Capital S t r u c t u r e 285 EBIT $ 3,000 Profit before taxes 3,000 Taxes 1,200 Profit after taxes .$Tm =1; required equity return .18 Value if unlevered $-10,000 ($10 million) ,(2) Value with $4 million in debt:Value = Value if
(2) It is lower because Zoom uses less debt in its capital structure. As the equity capitalization is a linear function of the debt-to-equity ratio when we use the net operating income approach, the decline in required equity return offsets exactly the disadvantage of not employing so much in the
b. (1)Total value of firm $2,000,000 Market value of debt (~20,% ) 400.000 Market value of equity (80%) $1,600,000 Net operating income $ 360,000 Interest on debt (8%) 32,000 Earnings to common $ 328,000 Implied required equity return = $328,000/$1,600,000 = 20.5%
(2) Implied required equity return = $280,000/$1,000,000 = 28%
3;- Solutions to Self- correction Problems Net operating income $ 360,000 Overall capitalization rate .18 Total value of firm $2,000,000 Market value of debt (50%) 1,000,000 Market value of stock (50%) $1,000,000 Net operating income $ 360,000 Interest on debt (8%) 80,000 Earnings to common $
10. Archer-Deloitte Company wishes to finance a $15 million expansion program and is trying to decide between debt and equity. Management believes the market does not appreciate the company's profit potential and that the stock is undervalued. What security do you suppose it will use in financing,
b. Does the value of the debt increase proportionally with the increase in its face value? Why or why not?284 Part 111 Financing and Dividend Policies
a. What is the effect on the value of the stock and on the value of the debt if the standard deviation is 50 percent?
9. Suppose in Problem 8 that Mohave Sand and Transit Company decided to issue$2 million in additional debt (face value) with a 3-year maturity and to repurchase$2 million in stock.
c. Does one party gain at the expense of the other? If this is the case, how can the other party protect itself?
b. If the company were to increase the riskiness of its business so that the standard deviation became 50 percent, what would happen to the value of the stock and to the value of the debt?
a. Treating the stock as an option and using the Black-Scholes option model, Eq. (5-3) in Chapter 5, determine the value of the equity and the value of debt.
8. Mohave Sand and Transit Company currently has an overall value of $8 million.The debt has a face value of $4 million and is represented by discount bonds that mature in 3 years. The standard deviation of the continuously compounded rate of return on overall value is 20 percent. The short-term
b. With bankruptcy and agency costs, what is the optimal capital structure?
a. (1) At a tax rate of 50 percent (federal and state), what is the weighted average cost of capital of the company at various leverage ratios in the absence of bankruptcy and agency costs? (2) What is the optimal capital structure?
7. Acme-Menderhall Corporation is trying to determine an appropriate capital structure. It knows that as its leverage increases, its cost of borrowing will eventually increase, as will the required rate of return on its common stock.The company has made the following estimates for various leverage
6. Petroles Vintage Wine Company is presently family owned and has no debt.The Petroles family is considering going public by selling some of their stock in the company. Investment bankers tell them the total market value of the company is $10 million if no debt is employed. In addition to selling
c. What would be the tax advantage if the personal tax rate on common stock income were (1) 30 percent? (2) 20 percent? (Assume that all else stays the same.)
b. Determine the tax advantage with both corporate and personal income taxes. Why does your answer to part b differ from that to part a?
a. Determine the tax advantage to Loveless Electrical Products Company for the use of debt under the assumption of corporate income taxes but no personal income taxes. (Assume the debt is perpetual and that the tax shield will be the same throug- hout.)
5. Loveless Electrical Products Company has $4 million in debt outstanding.The corporate income tax rate is 35 percent. In an extensive study of investors, G. Rosenberg and Associates, an outside consulting firm, has estimated that the marginal personal tax rate on common stock income for investors
c. The required return on equity for the company's stock is 20 percent while it remains all equity financed. What is the value of the firm?What is the value if it is recapitalized?
b. What is the present value of the debt tax shield?
a. If the corporate tax rate is 40 percent, what is the income to all security holders (1) if the company remains all equity financed? (2) if it is recapitalized?
4. Zapatta Cottonseed Oil Company has $1 million in earnings before interest and taxes. Currently it is all equity financed. It may issue $3 million in per282 Part 111 Financing and Dividend Policies petual debt at 15 percent interest to repurchase stock, thereby recapitalizing the corporation.
c. Are your conclusions in part a confirmed?
b. Construct a graph in terms of k,, k, and k, based on the data given.
a. By observation, what do you think is the optimal capital structure?
3. The Blalock Corporation has a $1 million capital structure and will always maintain this book-value amount. Blalock currently earns $250,000 per year before taxes of 50 percent, has an all-equity capital structure of 100,000 shares, and pays all earnings in dividends. The company is considering
b. When will this arbitrage process cease?
a. You own $22,500 worth of Green stock. Show the process and the amount by w ch you could reduce your outlay through the use of arbitrage.
2. The Kelly Company and the Green Company are identical in every respect except that the Kelly Company is not levered, while the Green Company has$2 million in 12 percent bonds outstanding. There are no taxes, and capital markets are assumed to be perfect. The valuation of the two firms is the
b. Determine the answers to part a if the company were to sell the additional$10 million in debt.Chapter 9 Theory of Capital Structure 281
a. Using the net operating income approach and an overall capitalization rate of 11 percent, compute the total market value, the stock market value, and the implied required return on equity for the Malock Company prior to the sale of additional debt.
3. UEtoile du Nord Resorts is considering various levels of debt. Presently, it has no debt and a total market value of $15 million. By undertaking leverage, it believes that it can achieve a net tax advantage (corporate and personal combined)equal to 20 percent of the amount of the debt. However,
a. Why do your answers differ?
b. Personal as well as corporate taxes now exist. The marginal personal tax rate on common stock income is 25 percent, and the marginal personal tax rate on debt income is 30 percent. Determine the value of the company using Eq. (9-12) for each of the three debt alternatives in part
a. In the absence of personal taxes, what is the value of the company in an MM world (1) with no leverage? (2) with $4 million in debt? (3)with $7 million in debt?
2. Massey-Moss Corporation has earnings before interest and taxes of $3 million and a 40 percent tax rate. Its required rate of return on equity in the absence of borrowing is 18 percent.
b. Zoom has the same net operating income as Abacus. (1) What is the implied required equity return of Zoom? (2) Why does it differ from that of Abacus?
1. Abacus Calculation Company and Zoom Calculators, Inc., are identical except for capital structures. Abacus has 50 percent debt and 50 percent equity, whereas Zoom has 20 percent debt and 80 percent equity. (All percentages are in market-value terms.) The borrowing rate for both companies is 8
4. The absence of corporate income taxes is assumed. MM remove this assumption later.
3. Firms can be categorized into "equivalent return" classes. All firms within a class have the same degree of business risk. As we shall see later, this assumption is not essential for their proof.
2. The average expected future operating earnings of a firm are represented by subjective random variables. It is assumed that the expected values of the probability distribution of all investors are the same. The MM illustration implies that the expected values of the probability distributions of
1. Capital markets are perfect. Information is costless and readily available to all investors. There are no transactions costs, and all securities are infinitely divisible. Investors are assumed to be rational and to behave ac-- ~
4. The expected values of the subjective probability distributions of expected future operating earnings for each company are the same for all investors in the market.5. The operating earnings of the firm are not expected to grow. The expected values of the probability distributions of expected
3. The fir111 has a policy of paying 100 percent of its earnings in dividends.Thus, we abstract from the dividend decision.254 Part 111 Financing and Dividend Policies
2. The ratio of debt to equity for a firm is changed by issuing debt to repurchase stock or issuing stock to pay off debt. In other words, a change in capital structure is effected immediately. In this regard, we assume no transaction costs.
1. There are no corporate or personal income taxes and no bankruptcy costs.(Later, we remove these assumptions.)
b. To pay this price, the assumptions of the CAPM must hold. The company is being valued according to its systematic risk only. The effect of the acquisition on the total risk of Williams Warbler Company is assumed not to be a factor of importance to investors. Additionally, we assume that the
5.a. The estimated required rate of return for the acquisition is Using this rate to discount the net cash flows, we obtain Net Cash Present-Value Present Years flow Factor Value The maximum price that should be paid is $642,264.
b. If the CAPM approach gives an opposite decision, the key to deciding would be the importance of market imperfections. As indicated earlier, if a company's stock is traded in imperfect markets, if the possibility of insolvency is substantive, and if bankruptcy costs are significant, more reliance
4.a. The coefficients of variation (standard deviation/NPV) for the alternatives are Existing projects .50 Plus project 1 .60 Plus project 2 .61 Plus projects 1 and 2 .63 The cdcient of variation increases with either or both investments. A reasonably risk-averse decision maker will prefer the
3. If the proxy companies are used in a CAPM approach, it is clear that different systematic risks are involved in the two divisions. The proxy companies in the health food business have more debt than Novus Nyet Company. In this case, the beta probably should be adjusted for leverage, using the
2. Through trial and error, one ends up using 18 percent and 19 percent as discount rates.Present Present End of Year Dividend per Share Value at 18% Value at 19%- - - -Present value, 1-5 years = -$5.26 $5.13 =Year 6 dividend = $2.49(1.10) = $2.74 Market prices at the end of year 5 using a
The greater the risk-free rate, the greater the expected return on the market portfolio and the greater the beta, the greater will be the required return on equity, all other things being the same. In addition, the greater the market risk premium (Rm - Rf), the greater the required return, all
b. What is the required return for the project? What assumptions are critical?(Note: To solve, you may use the technique described in the special section"Calculating Betas Manually.")m; Solutions to Self- correction Problems Situation Equation Required Return 1 10% + (15% - 10%)1.00 15.0%2 14% +
a. Compute the beta for Super Splash Spinning Corporation.
Litzenberger believes that the average annual return for the market index and the average annual return for the risk-free rate over the 10-year period are reasonable proxies for the returns likely to prevail in the future.Chapter 8 Creating Value through Required Returns 237
13. The North Bend Bait Company is contemplating an investment to get it into the production and sale of spinning rods and reels. Heretofore, it has produced only artificial baits. The financial manager of the company, Bruno Litzenberger, feels that the only way to analyze the merit of the project
c. Would your answer be the same if the acquisition increased the surviving company's growth rate to 8 percent forever?
b. Would your answer be the same if the overall required rate of return stayed the same?
a. Should Cougar Pipe Company acquire Red Wilson Rod, Inc.?
12. Cougar Pipe Company is considering the cash acquisition of Red Wilson Rod, Inc., for $750,000. The acquisition is expected to result in incremental cash flows of $125,000 in the first year, and this amount is expected to grow at a 6 percent compound rate. In the absence of the acquisition,
b. With a firm-risk approach to evaluating risky investments, which portfolio do you prefer?
a. Plot these various portfolio possibilities on graph paper.
. EA plus 1,2,3, and 4 kpected let Present Value$30 33 32 35 34 35 38 37 37 36 39 40 39 42 41 44 Standard Deviation$20 23 21 24 25 23 25 26 24 25 28 26 27 30 28 31 236 Part I1 investment in Assets and Required Returns
15. EA plus 2,3, and 4
14. EA plus 1,3, and 4
13. EA plus 1,2, and 4
12. EAplus 1,2, and 3
11. EA plus 3 and 4
10. EAplus 2 and 4
9. EA plus 2 and 3
8. EA plus 1 and 4
7. EA plus 1 and 3
6. EAplus 1 and 2
5. EA plus 4
4. EA plus 3
3. EA plus 2
2. EA plus 1
1. Existing assets (EA) only
11. The Empire Mining Company's existing portfolio of assets has an expected net present value of $30 million and a standard deviation of $20 million. The company is considering four new explorations. The 16 possible portfolios have the following characteristics (in millions):Possible Pottfolio
b. In words, what would happen to your answer to Problem 9a if market imperfections made unsystematic risk a factor of importance?
10.a. In your answer to Problem 9a, what would happen if Ponza International had a debt-to-total-capitalization ratio of 40 percent and intended to finance each of the projects with 40 percent debt, at a 6 percent after-tax interest cost, and 60 percent equity? (Assume that everything else was the
b. What are the assumptions involved in your acceptance criterion?
a. Which projects should be accepted and which rejected?
The expected return on the market index is 13 percent in the foreseeable future, and the risk-free rate is currently 7 percent. The divisions are evaluating a number of projects, which have the following expected returns:Chapter 8 Creating Value through Required Returns 235 Project Division
9. Ponza International, Inc., has three divisions. One is engaged in leisure wear, one in graphics, and one in household paint. The company has identified proxy companies in these lines of business whose stocks are publicly traded.Neither Ponza International nor the proxy companies employ debt in
b. What would happen if expected after-tax cash flows were $8,000 per year instead of $10,000?
a. What is the adjusted present value (APV) of the project? Is the project acceptable?
8. Grove Plowing, Inc., is considering investing in a new snowplow truck costing$30,000. The truck is Likely to provide a cash return after taxes of $10,000 per year for 6 years. The unlevered cost of equity capital of the company is 16 percent. The company intends to finance the project with 60
7. The Tumble Down D Ranch in Montana is considering investing in a new mechanized barn, which will cost $600,000. The new barn is expected to save$90,000 in annual labor costs indefinitely (for practical purposes of computation, forever). The ranch, which is incorporated and has a public market
b. Is the figure computed an appropriate acceptance criterion for evaluating investment proposals?
a. Compute the firm's present weighted average cost of capital.
6. The Kalog Precision Tool Company was recently formed to manufacture a new product. The company has the following capital structure in market value terms:13% debentures of 2005 $ 6,000,000 12% preferred stock 2,000,000 Common stock (320,000 shares) 8,000,000 Total $16,000,000 234 Part I1
d. The same common stock if dividends are expected to grow at the rate of 5 percent per year and the expected dividend in year 1 is $2.
c. A common stock selling at $16 and paying a $2 dividend, which is expected to be continued indefinitely.
b. A preferred stock, sold at $100 with a 10 percent coupon and a call price of $110, if the company plans to call the issue in 5 years (use an approximation method).
a. A bond, sold at par, with a 10.40 percent coupon.
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