Question 4 [15 Points]:

XYZ Inc. does not have a target debt-to-value ratio, but it has $1 million of risk-free debt in its capital structure (which was supposed to remain at this level forever). Debt is trading at par and has a coupon rate of 3%. Market value of equity is $4 million and there are 100,000 shares outstanding. You can assume that XYZ has only debt and equity in its capital structure and therefore its total market value is $5 million. Debt is 20% of total market value of the firm. Beta (b) for XYZs equity is currently 1.2.

A new management team has replaced the old management, and the new team at XYZ is planning to adopt a new policy regarding its debt and it wants to have a target debt-to-value ratio of 25%. In order to achieve the new target level of debt, the management of XYZ is planning to issue some new debt and it has announced that the new debt will be used to buy back some shares and it will not be used for any new investment. Analysts have said that debt will still be risk-free. The corporate tax rate for XYZ is 30%. There are no personal taxes. If XYZ issues additional debt in order to achieve the target level of debt, then

1. How much new debt should be issued?
2. What will be the new firm value according to Modigliani-Millers theory in the presence of corporate taxes?
3. What is your estimate of the equity Beta (b) after the issuance of the new debt?
4. What will be the new share price?

(A word of caution: When additional debt is issued, the firm value will change from its current $5 million because of additional tax shield created by the new debt.)

Question 5 [15 Points]:

A company is thinking about replacing an old machine with a new one. The old machine cost $1.3 million. The new machine will cost $1.56 million. The new machine will be depreciated according to 5-year MACRS, and will be sold at $300,000 after 5 years. The new machine will require an investment of $150,000 in working capital, which can be recovered after 5 years.

The old machine is being depreciated at a rate of $130,000 per year to a book value of zero in 5 years, and can be sold for $50,000 after 5 years. It can be sold for $300,000 now. The company is in a 30% tax bracket and applies a 12% discount rate.

The new machine will save $250,000 in operating costs per year. There is no change in revenues.

1. If the new machine is purchased today,

1. Then what is the total investment today?

(ii) What will be the depreciation (in $) on the new machine for the next 5 years?

(iii) What will be the after-tax salvage value of the machine after 5 years?

2. If the old machine is sold today after the new machine is bought,

1. Then what is the after-tax salvage value from the sale of the old machine?

(ii) What will be the annual after-tax operating cash-flow from the operating cost savings from the new machine and the incremental depreciation?

3. If the new machine is bought and the old machine is sold, then what is the incremental cashflows for at time t = 0 and at time t = 5?

4. Based on your answers to (a), (b), and (c), can you calculate the NPV of all the incremental cash-flows of buying the new machine and selling the old machine for t = 0 to t = 5? Should the new machine be bought?