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principles corporate finance

Corporate Finance 6th International Edition Stephen Ross, Randolph Westerfield, Jeffrey Jaffe - Solutions

17.3 MEO Foods, Inc., has made cat food for over 20 years. The company currently has a debtequity ratio of 25 percent, borrows at a 10-percent interest rate, and is in the 40-percent tax bracket. Its shareholders require an 18-percent return.MEO is planning to expand cat food production capacity.
17.7 Value Company has compiled the following information on its financing costs:Value is in the 34-percent tax bracket and has a target debt-equity ratio of 100 percent. Value’s managers would like to keep the market values of short-term and long-term debt equal.a. Calculate the weighted average
17.14 Schwartz & Brothers Inc. is in the process of deciding whether to make an equity investment in a project of holiday gifts production and sales. Arron Buffet is in charge of the feasibility study of the project. To better assess the risk of the project, he used the average of 10 other
17.16 North Pole Fishing Equipment Corp. and South Pole Fishing Equipment Corp. would have identical of 1.2 if both of them were all-equity financed. The capital structures of the two firms are as follows:The expected market rate of return is 12.75 percent, and the three-month Treasury bill rate is
17.15 Brenda Lynch, CFO of Hunter Enterprises, is evaluating a 10-year, 9-percent loan. The projected net proceeds after flotation costs to be raised by the loan are $4,250,000. The flotation costs are estimated to be 1.25 percent of the gross proceeds and will be amortized using a straight-line
17.13 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
17.12 Kinedyne, Inc., has decided to divest one of its divisions. The assets of the group have the same operating risk characteristics as those of the parent firm. The capital structure for the parent has been stable at 40-percent debt/60-percent equity (in market-value terms), the level determined
17.11 ABC, Inc., is an unlevered firm with expected perpetual annual before-tax cash flows of$30 million and required return on equity of 18 percent. It has 1 million shares outstanding. ABC is paying tax at a marginal rate of 34 percent. The firm is planning a recapitalization under which it will
17.10 Refer to question 17.8.Baber Corporation has chosen to purchase the additional equipment. If Baber funds the project entirely with debt, what is the firm’s weighted average cost of capital? Explain your answer
17.9 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.
17.8 Baber Corporation’s stock returns have a covariance with the market of 0.031. The standard deviation of the market returns is 0.16, and the historical market premium is 8.5 percent.Baber bonds carry a 13-percent coupon rate and are priced to yield 11 percent. The market value of the bonds is
17.6 The overall firm beta for Wild Widgets, Inc., (WWI) is 0.9. WWI has a target debt-equity ratio of 1/2. The expected return on the market is 16 percent, and Treasury bills are currently selling to yield 8 percent. WWI one-year bonds that carry a 7-percent coupon are selling for $972.72. The
17.5 Milano Pizza Club owns a chain of three identical restaurants popular for their Milan style pizza. Comparable stores have an equity value of $900,000 and debt-to-equity ratio of 30 percent. The prevailing market interest rate is 9.5 percent. An equivalent all-equityfinanced store would have a
17.4 Roller and Decker Corp. has established a joint venture with Malaysia Road Construction Company to build a toll road in Malaysia. The initial investment in paving equipment is$20 million. Straight-line depreciation will be used, and the equipment has an economic life of five years with no
17.2 Peatco, Inc., is considering a $2.1 million project that will be depreciated according to the straight-line method over the three-year life of the project. The project will generate pretax earnings of $900,000 per year, and it will not change the risk level of the firm. Peatco can obtain a
17.1 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
3. The J. Lowes Corporation, which currently manufactures staples, is considering a$1 million investment in a project in the aircraft adhesives industry. The corporation estimates unlevered after-tax cash flows (UCF) of $300,000 per year into perpetuity from the project. The firm will finance the
2. C. F. Lee Incorporated is considering a scale-enhancing project. The market value of the firm’s debt is $100 million, and the market value of the firm’s equity is $200 million. The debt is considered riskless. The corporate tax rate is 34 percent. Regression analysis indicates that the beta
1. World-Wide Enterprises (WWE) is a large conglomerate thinking of entering the widget business, where it plans to finance projects with a debt-to-value ratio of 25 percent (or, alternatively, a debt-to-equity ratio of 1/3). There is currently one firm in the widget industry, American Widgets
• How is the WACC method applied?
• What information is needed to calculate FTE?
• How is the FTE method applied?
• What additional information beyond NPV does one need to calculate APV?
• How is the APV method applied?
16.19 Consider an economy with three investor groups with marginal personal tax rate of 10 percent, 20 percent, and 40 percent, respectively. The corporate tax rate is 35 percent.Assume zero personal tax rate on equity income. The required rate of return on all-equity financed projects is 11
16.17 The Gulf Power Company is an electric utility planning to build a new power-generating plant of conventional design. The company has traditionally paid out all earnings to the stockholders as dividends and financed capital expenditures with new issues of common stock. There is no debt or
16.16 Melvin Clark, CFO of the Matsushita Corp., is evaluating the value of the firm’s current capital structure. Being conservative, he expects that Matsushita will have a perpetual EBIT of $800,000, with an after-tax discount rate of 10 percent if it is all-equity financed.Currently, the firm
16.15 Mueller Brewing Company has been ordered by the EPA to stop polluting the Menomenie River. It must now spend $100 million on pollution-control equipment. The company has three alternatives for obtaining the needed $100 million.1. Sell $100 million of perpetual, taxable corporate bonds with a
16.14 The EXES Company is assessing its present capital structure and that structure’s implications for the welfare of its investors. EXES is currently financed entirely with common stock, of which 1,000 shares are outstanding. Given the risk of the underlying cash flows (EBIT) generated by EXES,
16.13 Because of the large cash inflows from the sales of its cookbook, Fear of Frying, the Overnight Publishing Company (OPC) has decided to retire all of its outstanding debt.The debt is made up of consul bonds; its maturity date is indefinitely far away. The debt is also considered risk-free. It
16.10 What are the sources of the agency costs of equity?
16.9 How would the consideration of financial distress costs and agency costs affect the MM proposition in a world where corporations pay taxes?
16.8 What measures do stockholders undertake to minimize the costs of debt?
16.7 Refer to the selfish strategy in section 16.5. Suppose the bondholders are fully aware of the discrepancy between maximizing the firm value and the stock value. To minimize the agency costs, bondholders use a bond covenant to stipulate that when the firm takes on high-risk projects,
16.6 Do you agree or disagree with the following statement? Explain your answer.A firm’s stockholders would never want the firm to invest in projects with negative NPVs.
16.3 What are the direct and indirect costs of bankruptcy? Briefly explain each.
16.2 VanSant Corporation and Matta, Inc., are identical firms except that Matta, Inc., is more levered than VanSant. The companies’ economists agree that the probability of a recession next year is 20 percent and the probability of a continuation of the current expansion is 80 percent. If the
• What are the factors to consider in establishing a debt-equity ratio?
• List the empirical regularities we observe for corporate capital structure.
• How do growth opportunities decrease the advantage of debt financing?
• What is financial slack?
• What are the problems of issuing equity according to this theory?
• What is the pecking-order theory?
• What is the free cash flow hypothesis?
• How do agency costs of equity affect the firm’s debt-equity ratio?
• Why are shirking and perquisites considered an agency cost of equity?
• How can a firm maximize the value of its marketed claims?
• Describe marketed claims and nonmarketed claims.
• List all the claims to the firm’s assets.
• Who pays the costs of selfish strategies?
• What are the indirect costs of financial distress?
• What is the main direct cost of financial distress?
• Why do we say that stockholders bear bankruptcy costs?
• Can one have bankruptcy risk without bankruptcy costs?
• What does risk neutrality mean?
15.21 AT&B has a debt-equity ratio of 2.5. Its rWACC is 15 percent and its cost of debt is 11 percent. The corporate tax rate is 35 percent.a. What is AT&B’s cost of equity capital?b. What is AT&B’s unlevered cost of equity capital?c. What would the weighted average cost of capital be if the
15.19 Green Manufacturing, Inc., plans to announce that it will issue $2,000,000 of perpetual bonds.The bonds will have a 6-percent coupon rate. Green Manufacturing currently is an all-equity firm. The value of Green’s equity is $10,000,000 and there are 500,000 shares outstanding.After the sale
15.17 Streiber Publishing Company, an all-equity firm, generates perpetual earnings before interest and taxes (EBIT) of $2.5 million per year. Streiber’s after-tax, all-equity discount rate is 20 percent. The company’s tax rate is 34 percent.a. What is the value of Streiber Publishing?b. If
15.16 An all-equity firm is subject to a 30-percent corporate tax rate. Its equityholders require a 20-percent return. The firm’s initial market value is $3,500,000, and there are 175,000 shares outstanding. The firm issues $1 million of bonds at 10 percent and uses the proceeds to repurchase
15.13 Old Fashion Corp. is an all-equity firm famous for its antique furniture business. If the firm uses 36-percent leverage through issuance of long-term debt, the CFO predicts that there is a 20-percent chance that the ROE will be 10 percent, a 40-percent chance that the ROE will be 15 percent,
15.11a. List the three assumptions that lie behind the Modigliani-Miller theory.b. Briefly explain the effect of each upon the conclusions of the theory for the real world.
15.9 The Gulf Power Company is an electric utility that is planning to build a new conventional power plant. The company has traditionally paid out all earnings to the stockholders as dividends, and has financed capital expenditures with new issues of common stock. There is no debt or preferred
15.4 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 per year in perpetuity, and each company distributes all its earnings. Levered’s debt has a market value of $275
15.3 You invest $100,000 in the stock of the Liana Rope Company. To make the investment, you borrowed $75,000 from a friend at a cost of 10 percent. You expect your equity investment to return 20 percent. There are no taxes. What would your return be if you did not use leverage?
• What is MM Proposition II under corporate taxes?
• What is MM Proposition I under corporate taxes?
• What is the quirk in the tax code making a levered firm more valuable than an otherwise identical unlevered firm?
• How are market-value balance sheets set up?
• What is the exact relationship between the expected return on equity and firm leverage?
• Why does the expected return on equity rise with firm leverage?
• How can a shareholder of Trans Am undo the company’s financial leverage?
• What is levered equity?
• Describe financial leverage.
1. Suppose the market value of the J. J. Sprint Company is $1,000. The company currently has no debt, and each of J. J. Sprint’s 100 shares of stock sells for $10. A company such as J. J. Sprint with no debt is called an unlevered company. Further suppose that J. J. Sprint plans to borrow $500
• What is the pie model of capital structure?
12.11 What factors determine the beta of a stock? Define and describe each
12.10 Is the discount rate for the projects of a levered firm higher or lower than the cost of equity computed using the security market line? Why? (Consider only projects that have similar risk to that of the firm.)
12.7 If you use the stock beta and the security market line to compute the discount rate for a project, what assumptions are you implicitly making?
12.1 Furniture Depot, Inc., is an all-equity firm with a beta of 0.95. The market-risk premium is 9 percent and the risk-free rate is 5 percent. The company must decide whether or not to undertake the project that requires an immediate investment of$1.2 million and will generate annual after-tax
• What can a corporation do to lower its cost of capital?
• What is the relation between liquidity and expected returns?
• What is liquidity?
• What is the difference between an asset beta and an equity beta?
• What are determinants of equity betas?
• What is the disadvantage of using the industry beta as the estimate of the beta of an individual firm?
• What is the disadvantage of using too many observations when estimating beta?
• What is the disadvantage of using too few observations when estimating beta?
1. Suppose the stock of the Quatram Company, a publisher of college textbooks, has a beta () of 1.3. The firm is 100-percent equity financed; that is, it has no debt. Quatram is considering a number of capital-budgeting projects that will double its size. Because these new projects are similar to
4.52 Ernie Els wants to save money to meet two objectives. First, he would like to be able to retire 30 years from now with a retirement income of $300,000 per year for 20 years beginning at the end of the 31 years from now. Second, he would like to purchase a cabin in the mountains 10 years from
4.51 Southern California Publishing Company is trying to decide whether or not to revise its popular textbook, Financial Psychoanalysis Made Simple. They have estimated that the revision will cost $40,000. Cash flows from increased sales will be $10,000 the first year.These cash flows will increase
4.50 A 10-year annuity pays $900 per year, with payments made at the end of each year. The first $900 will be paid 5 years from now. If the APR is 8% and interest is compounded quarterly, what is the present value of this annuity?
4.49 You want to lease a set of golf clubs from Pings Ltd. for $4,000. The lease contract is in the form of 24 months of equal payments at a 12% annual percentage rate (APR). Suppose payments are due in the beginning of the month and your first payment is due immediately. What will your monthly
4.48 Justin Leonard has just arranged to purchase a $400,000 vacation home in the Bahamas with a 20% down payment. The mortgage has an 8% annual percentage rate (APR) and calls for equal monthly payments over the next 30 years. His first payment will be due one month from now. However, the mortgage
4.47 Ms. Adams has received a job offer from a large investment bank as an assistant to the vice president. Her base salary will be $35,000. She will receive her first annual salary payment one year from the day she begins to work. In addition, she will get an immediate $10,000 bonus for joining
4.46 In January 1984, Richard “Goose” Gossage signed a contract to play for the San Diego Padres that guaranteed him a minimum of $9,955,000. The guaranteed payments were$875,000 for 1984, $650,000 for 1985, $800,000 in 1986, $1 million in 1987, $1 million in 1988, and $300,000 in 1989. In
4.45 Your younger brother has come to you for advice. He is about to enter college and has two options open to him. His first option is to study engineering. If he does this, his undergraduate degree would cost him $12,000 a year for four years. Having obtained this, he would need to gain two years
4.44 When Marilyn Monroe died, ex-husband Joe DiMaggio vowed to place fresh flowers on her grave every Sunday as long as he lived. A bunch of fresh flowers that the former baseball player thought appropriate for the star cost about $5 when she died in 1962.Based on actuarial tables, “Joltin’
4.42 You are saving for your retirement. You have decided that one year from today you will deposit 2 percent of your annual salary in an account which will earn 8 percent per year.Your salary last year was $50,000, and it will increase at 4 percent per year throughout your career. How much money
4.41 Your company is considering leasing a $120,000 piece of equipment for the next 10 years.Your company can buy the equipment outright or lease it. The annual lease payments of$15,000 are due at the beginning of each year. The lease includes an option for your company to buy the equipment for
4.40 A well-known insurance company offers a policy known as the “Estate Creator Six Pay.”Typically the policy is bought by a parent or grandparent for a child at the child’s birth.The details of the policy are as follows: The purchaser (say, the parent) makes the following six payments to

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