Corp Finance - Second Half

Assume you estimate beta for each of 100 large firms listed in the US, using monthly returns, over a 5 year horizon. You wait five years and repeat the exercise, for the same firms, with the newly gathered data. What will you observe?

- Beta values for individual firms will not be identical over time. - Firms that had very low beta will tend to have low beta also in the future, while very high beta firms will tend to continue to have high beta, but the beta value may nevertheless change for any given firm. - The average beta, i.e. averaged across the 100 firms, changes very little.

AAA's balance sheet is as follows (all in market values) ASSETS Current assets 353 + Long term assets 2,395 LIABILITIES Debt 303 + Equity ?? According to MM's Proposition I corrected for taxes, what will be the change in company value if AAA issues 780 of equity and uses it to make a permanent reduction in the company's debt? Assume a 35% tax rate.

-273 PV(Tax Shield) = -780 x 0.35 = -273

A firm earns a pretax profit of $10 per share. The tax system is an imputation tax system. Assume that the corporate tax rate is 31 %. The firm pays whatever is left after corporate tax as dividends to a shareholder in the 31% tax bracket. What is the dollar amount of tax paid by the shareholder under the imputation tax system?

0

Given the following data:Cost of debt = rD = 0.018;Cost of equity = rE = 0.1123;Marginal tax rate = 35%;and the firm has 50% debt and 50% equity. Calculate the after-tax weighted average cost of capital (WACC), precise to four digits after the comma:

0.0620

The market value of AAA's common stock is 40 million and the market value of the risk-free debt is 60 million. The beta of the company's common stock is 1.41, and the expected market risk premium is 0.067. If the Treasury bill rate is 6%, what is the firm's cost of capital? give the answer in decimal form precise to three digits after the comma. (Assume no taxes)

0.0978

A firm is using $30 million in debt, $10 million in preferred stock and $60 million in common equity to finance its assets. If the before tax cost of debt is 8%, cost of preferred stock is 10% , and the cost of common equity is 15%; calculate the weighted average cost of capital for the firm assuming a tax rate of 35%, with three digits after the comma (that is, not in percentage terms).

0.115

A firm is financed with 187 debt, 719 common equity and 676 preferred equity. The before-tax cost of debt is 5%, the firm's cost of common equity is 15%, and that of preferred equity is 10%. The marginal tax rate is 30%. What is the firm's weighted average cost of capital?

0.1150

AAA Company is financed entirely by stock that is priced to offer an expected return of rE=0.13. If the company repurchases 50% of the stock and substitutes an equal value of debt yielding 8%, what is the expected return on the common stock after refinancing? Calculate your answer precise to 2 digits after the comma.

0.18

The historical returns data for the past three years for AAA's stock is -6.0%, 15%, 15% and that of the market portfolio is 10%, 10% and 16%. If the risk-free rate of return is 4%, what is the cost of equity capital according to the CAPM? Calculate your answer IN DECIMAL form, and precise to two digits after the comma.

0.18

A firm has zero debt in its capital structure. Its overall cost of capital is 14%. The firm is considering a new capital structure with 60% debt. The interest rate on the debt would be 8%. Assuming there are no taxes, its cost of equity capital with the new capital structure would be (provide your answer in decimal form, correct to 2 digits after the comma):

0.23

Assume the following data for AAA Corporation: Market price/share = 19 Book value/share = 11 Number of shares outstanding = 119,707,025 Market price/bond = 1,060 Face value/bond = 1000 Number of bonds outstanding = 983,083 Calculate, in decimal form, the proportion of equity (E/V) for the firm that you would use for estimating the weighted average cost of capital (WACC), precise to 4 digits after the comma.

0.6857

A firm's equity beta is 1.2 and its debt is risk free. Given a 0.7 debt to equity ratio, what is the firm's asset beta?

0.7

The beta of an all equity firm is 0.52. If the firm changes its capital structure to 50% debt and 50% equity using 8% debt financing, what will be the equity beta of the levered firm? The beta of debt is 0.2. (Assume no taxes.) Provide your answer with 2 digits after the comma.

0.84

Arrange the events around a dividend payment in chronological order from earliest to latest.

1. declaration date 2. ex-dividend date 3. record date 4. payment date

The relative tax advantage of debt with personal and corporate taxes is: Where: TC= (Corporate tax rate) = 35%; TPE= Personal tax rate on equity income = 30%; and TP= Personal tax rate on interest income = 20%: (approximately)

1.76

You want to estimate the appropriate discount rate for a new project. For this, you find that there is a comparable firm ABC being traded on financial markets with the following data: debt-equity ratio 1.00, and equity beta 1.5. The current T.Bill rate is 4 percent and the market risk premium is 8 percent. Assume that the debt of firm ABC is risk-free. What is the appropriate discount rate for the project?

10 percent

Assume the corporate tax rate is 30%. The firm has no debt in its capital structure. It is valued at $100 million. What would be the value of the firm if it issued $51 million in perpetual debt and repurchased the equity? Give the actual number, not in millions.

115,300,000

A firm's expected dividend payment in one year is 10. Dividends are then expected to grow with a constant growth of 2% a year. The required return on the stock is 10%. What is the stock price today?

125.0

AAA Company is financed entirely by common stock that is priced to offer a 15 percent expected return. If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected return on the common stock after refinancing?

18 percent

A project costs $7 million and is expected to produce cash flows if $2 million a year for 10 years. The opportunity cost of capital is 16%. If the firm has to issue stock to undertake the project and issue costs are $0.5 million, what is the project's APV?

2.17 million

Firm XXX has a project with a beta of 1.5 and cash flows of 100 in year t+1 and 200 in year t+3. The risk free rate is 5% and the expected market return is 10%. Today, what would be your maximum willingness to pay for this project?

229

AAA Company is financed entirely by common stock that is priced to offer a 20% expected rate of return. The stock price is $60 and the earnings per share are $12. If the company repurchases 50% of the stock and substitutes an equal value of debt yielding rD=0.016, what is the expected earnings per share value after refinancing? (Hint: This is a challenging question!) Calculate your answer precise to two digits after the comma.

23.04

Company X has 100 shares outstanding. Its required rate of return is 10%. It earns $ 35,598 per year and expects to pay all of it as dividends. The first dividend is paid in exactly one year. Assume the firm expects to maintain this dividend forever. Ignore complications such as ex dividend dates, etc for this exercise. What is the stock price today, i.e. one year before the dividend payment? Specify your answer precise to 2 digits after the comma.

3559.80 DIV = EPS x Payout Ratio DIV = 355.98 Po = 355.98/0.1 Po = 3559.80

Compute the present value of interest tax shields generated by the following three debt issues a company is considering. Consider corporate taxes only. Assume the appropriate discount rate is identical to the yield of the debt. The marginal tax rate is Tc=40 percent. ONE is a USD1,200 one-year loan at 9 percent. TWO is a seven-year loan of USD1,200 at 9 percent, no principal is repaid until maturity. THREE is a USD1,200 perpetuity at 8 percent. Select all three correct solutions.

39.63 217.42 480.00

If a firm permanently borrows $22 million at an interest rate of i=2%, what is the present value of the interest tax shield? Assume that the tax rate is 30%. Insert the actual number, not in millions. Calculate your answer precise with all significant digits.

6,600,000

Firm X expects to generate cash flows of $10 next year and then expects, due to competition, a decrease in its future cash flows at a rate of 6% per year in perpetuity. The appropriate discount rate is 10%. What is the present value of all firm X cash flows?

62.5

AAA Company is financed entirely by common stock that is priced to offer a 15% expected return. The common stock price is $40/share. Earnings per share (EPS) is expected to be $6. If the company repurchases 25% of the common stock and substitutes an equal value of debt yielding rD=0.014, what is the expected value of earnings per share after refinancing, precise to two digits after the comma? Assume no taxes.

7.81

Given the following data: FCF year 1 = $7 million; FCF year 2 = $45 million; FCF year 3 = $55 million; free cash flow grows at a rate of 4% for year 4 and beyond. If the weighted average cost of capital is 10%, calculate the value of the firm. Please provide your number rounded to full dollars, no digits after the comma (in dollars, not in millions of dollars!).

801,129,477

Cost of capital is the same as cost of equity for firms that are (select all that apply):

Financed entirely by common stock Financed entirely by equity

When financial distress is a possibility, the value of a levered firm consists of: I) Value of the firm if all-equity-financed II) Present value of tax shield III) Present value of costs of financial distress IV) Present value of omitted dividend payments

I + II - III

Which statements regarding the general approach of valuing investment projects using WACC to capture the tax benefit of debt financing are CORRECT?

In calculating present value, the 'mistake' in forecasting after-tax cashflows assuming 100% equity financing in the nominator is corrected by adjusting the discount rate for tax benefits in the denominator. Cash flows are forecasted after-tax, as if the firm was 100% equity financed (even if the firm is not 100% equity financed in reality) The tax benefit of debt financing is captured solely by adjusting the discount rate

Subsidized loans have the effect of

Increasing the NPV of the loan, thereby increasing the APV

Taking all pros and cons of payout policy into account, what can be safely stated

Investors care about the information content of payout policy. An important factor of payout policy is the life cycle of the firm, where young growth firms typically pay no or little money out to shareholders, while established and mature firms make larger payouts to shareholders via dividends and repurchases, or are more likely to make any payouts. If we live in an imperfect world with imperfect capital markets, then dividend and repurchasing policy may destroy or create value.

Assume a tax system where there is a corporate tax rate of 35%, no personal taxes on capital gains, but personal taxes on interest income (with a tax rate to be specified). In this tax system, a company can direct $1 to either debt interest or capital gains for equity investors. Which of the following investors would not care how the money was channeled?

Investors paying personal tax of 35%

Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to:

Meet both interest and dividend payments which when met increase the firm cash flow Not breach convents typically attached to the debt, since covenant violations will trigger actions such as penalties applied or the debt being called.

According to the trade-off theory of capital structure:

Optimal capital structure is reached when the present value of tax savings on account of additional borrowing is just offset by increases in the present value of costs of distress

gordon growth model

P0= Div1/ (r-g) r= required rate of return g= dividend growth rate div1= dividend a year from now

The ABC company is in financial distress, has USD10,000 in cash, and debt with face value USD50,000 due next year. The ABC company has the possibility to invest in a project which requires an investment of all of its USD10,000 cash and is expected to produce a cash flow next year of USD100,000 with probability 5 percent, and USD10,000 otherwise. Assume a discount rate of 20 percent throughout. By implementing the project versus doing nothing, by how much does shareholder value increase?

Roughly 2083

An investment A with a beta of 0.5 has an expected return of 8%. Another investment B with a beta of 0 has an expected return of 2%. Yet another investment C has an expected return of 10%. Which statements are correct? Assume that the CAPM holds throughout. An investment with a beta of 2 has an expected return of 16% The beta of investment C should be 2/3. The market risk premium is 9% The market risk premium is 12% An investment with a beta of 2 has an expected return of 26% The beta of investment C should be 4/5.

The beta of investment C should be 2/3. The market risk premium is 12% An investment with a beta of 2 would have an expected return of 26%

AAA Company is financed entirely by common stock that is priced to offer a 15 percent expected return. The common stock price is USD 40 per share. The earnings per share (EPS) is expected to be USD 6. If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected value of earnings per share after refinancing? (Ignore taxes.)

USD 7.20

Assume MM assumptions of perfect capital markets hold. If firm U is unlevered and firm L is levered, then which of the following is true? Select all that apply.

V(L) = E(L) + D(L) V(U) = E(U)

MM's Proposition I corrected for the inclusion of corporate income taxes is expressed as:

V(U) = V(L) - (Tc X D)

The after-tax weighted average cost of capital (WACC) is calculated using the formula:

WACC = (rD) (1 - Tc) (D/V) + (rE) (E/V) where: V = D + E

On a graph with stock returns on the Y-axis and market returns on the X-axis, the slope of the regression line represents

beta

under imputation tax system,

investors are given a tax credit for corporate payment/tax

Assume MM holds, and there are no taxes, and rA>rD, then increasing the D/E ratio causes (select all that apply)

rD to stay constant, up to a point rA to stay constant rD to increase beyond a point where bankruptcy risk increases rE to increase at a slower rate beyond a point where bankruptcy risk increases rE to increase at a constant rate, up to a point

Firms can pay out earnings to their shareholders in the following ways

repurchasing shares in a tender offer to shareholders special cash dividends repurchasing shares in the open market regular cash dividends

Asset betas tend to be larger in (select all answers that apply):

sectors that face large cyclicality of revenues and large operating leverage

Under an imputation tax system,

shareholders may pay a higher effective tax rate than the corporate tax rate. shareholders receive a tax credit for the corporate tax the firm pays.

NOT TRUE: under a US tax system

shareholders receive a tax credit for the corporate tax the firm pays. the maximum effective tax rate shareholders pay is the corporate tax rate

If we take an MM-assumptions firm, and add taxes. Then, lowering the debt-equity ratio of a firm can change:

the cost of equity the effective tax rate the cost of debt the relative proportions of financing used by the firm

NOT TRUE: under an imputation tax system,

the maximum effective tax rate shareholders pay is the corporate tax rate

If the 5-year spot rate is 10% and the 4-year spot rate is 9%, which statements about the one-year forward rate of interest four years from now are correct?

the one-year forward rate of interest four years from now is 14.1% the one-year forward rate of interest four years from now is positive

Which statements about the Modigliani Miller Theorem II are correct?

Equity beta equals asset beta if the firm has no debt Equity returns increase in the debt-to-equity ratio

Given the following information, leverage will add how much value to an unlevered firm per dollar of debt? (Approximately) Corporate tax rate: 34%Personal tax rate on income from bonds: 30%Personal tax rate on income from stocks: 20%

$0.172

The company cost of capital is the appropriate discount rate for a firm's: High risk projects Low risk projects Riskless projects All of the other answers Average-risk projects

Average-risk projects

Company XYZ generates annual cash-flows equal to USD 1 million, in a perpetual way. The firm cost of capital is 10 percent, and the firm has a (perpetual) debt level equal to USD 2 million. Company XYZ is incorporated in a country that currently has a corporate tax of 0 percent. It follows that the market value of the assets of Company XYZ is USD 10 million. Suppose that the country announces unexpectedly that the marginal corporate tax rate is now equal to 10 percent. Assuming that the firm cost of capital remains the same, what is the change in the total market value of the assets of Company XYZ associated to the announcement?

Decrease by USD 0.8 million Change in value = Tc x E = 0.1*8 = 0.8

If both dividends and capital gains are taxed at the same ordinary income tax rate, the economic effect of tax may still be different because:

Dividends are taxed when distributed while capital gains are deferred until the stock is sold

Which of the following statements are INCORRECT? The company cost of capital is the correct discount rate for all projects because the high risks of some projects are offset by the low risk of other projects The company cost of capital is larger for firms with low debt-to-equity ratio Suppose a firm uses its company cost of capital to evaluate all projects. This firm will tend to underestimate the value of high-risk projects Suppose a firm uses its company cost of capital to evaluate all projects. This firm will tend to overestimate the value of high-risk projects

The company cost of capital is the correct discount rate for all projects because the high risks of some projects are offset by the low risk of other projects The company cost of capital is larger for firms with low debt-to-equity ratio Suppose a firm uses its company cost of capital to evaluate all projects. This firm will tend to underestimate the value of high-risk projects

Which statements about debt betas, equity betas and asset betas are false? The asset beta of a levered firm is the weighted average of equity and debt beta The debt beta of any firm is zero. The debt beta of a firm will generally be lower than the equity beta of that firm. The following ranking emerges for any firm: asset beta > equity beta > debt beta If the debt of a firm is risky, the firm's debt beta will be larger than zero. A firm with higher asset beta, other things equal, will have a higher weighted average costs of capital.

The debt beta of any firm is zero. The following ranking emerges for any firm: asset beta > equity beta > debt beta

What is MM's Proposition 2?

The expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expressed in market values; the rate of increase depends on the spread between rA and rD.

Company XYZ has currently 1 million dollars in cash and total debt due next year of around 3 million. The company expects zero profits next year unless it invests the 1 million dollars currently on the bank account in a new risky project. If implemented, this project will generate a payoff of 4 million dollars with a 20 percent probability, and nothing otherwise. Assume no discount rate. Which of the following statements is correct?

The investment is unprofitable for debtholders and profitable for shareholders

Modigliani and Miller's Proposition I states that:

The market value of any firm is independent of its capital structure

If a manager uses the firm's WACC to evaluate an investment project, what assumptions does she make?

The project's risks are identical to the risks of the firm's existing projects and remain unchanged for the lifetime of the project. The proportions of equity and debt used to finance the project will remain constant throughout the lifetime of the project. The project is financed in identical proportions of equity and debt as the firm's existing capital structure.

The AAA Company has a debt to total value ratio of 0.5. The cost of debt is 8 percent and that of unlevered equity is 12 percent. Which statements are correct? Select all that apply. The weighted average cost of capital is 12 percent if the tax rate is 30 percent The weighted average cost of capital is 14.8 percent if the tax rate is 30 percent. The return on assets is 16 percent The return on assets is 12 percent The weighted average cost of capital is 12 percent if the tax rate is 30 percent

The return on assets is 12 percent

The trade-off theory implies that all-else equal:

The tax shield of debt is higher for firms located in countries with higher corporate tax rates Firm value is lower for firms located in countries with higher corporate tax rates

Firm AAA is a mature business, but pays not dividends. Next year's earnings are forecasted at $56 million. There are 10 million shares outstanding. The company traditionally has paid out 50% of earnings as repurchases and reinvested the remaining amount. With reinvestment, the company has generated steady growth averaging 5% per year. Assume the cost of equity is 12%, the firm is 100% equity financed, and there are no taxes. Using the constant-growth perpetuity formula (!), you obtain a current stock price of $40 per share. Now assume AAA announces a switch from repurchases to regular cash dividends. Next year's dividend will be $2.80 per share. The CFO assures investors that the company will continue to pay out half of earnings and reinvest the other half. All future payouts will come as dividends however. How will the stock price of AAA change on the announcement of the switch in payout policy?

the stock price does not change

Firms can repurchase shares in several ways. Which ones?

through a Dutch auction process through open market repurchase through direct negotiation with a major shareholder through a tender offer

Assume a US firm. Operating income is 2000, the corporate tax rate is 35%, and income tax paid by the investors is 15%. What is the net income of the investor?

to find answer: multiply 2000 X (1-.35) = 1,300 now: 1,300 X (1-.15) = 1,105