Final Advanced Financial Management

Debt market value=

# of outstanding bonds X market price of one bond

The Yurdone Corporation wants to set up a private cemetery business. The cemetery project will provide a net cash inflow of $97,000 for the firm during the first year, and the cash flows are projected to grow at a rate of 4 percent per year forever. The project requires an initial investment of $1,500,000. If Yurdone requires an 11 percent return on such undertakings, should the cemetery business be started? The company is somewhat unsure about the assumption of a 4 percent growth rate in its cash flows. At what constant growth rate would the company just break even if it still required an 11 percent return on investment?

$-114285.71 4.53%

A project that provides annual cash flows of $17,300 for nine years costs $79,000 today. Is this a good project if the required return is 8 percent? What if it's 20 percent? At what discount rate would you be indifferent between accepting the project and rejecting it?

$29071.16 -$9264.48 16.25%

Metallica Bearings, Inc., is a young start-up company. No dividends will be paid on the stock over the next nine years because the firm needs to plow back its earnings to fuel growth. The company will pay a $12 per share dividend in 10 years and will increase the dividend by 5 percent per year thereafter. If the required return on this stock is 13.5 percent, what is the current share price?

$45.16

Sewer's Paradise is an all equity firm that has 5,000 shares of stock outstanding at a market price of $15 a share. The firm's management has decided to issue $30,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 10 percent. How many shares will the firm repurchase? What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes.

$50 4 M

What does a discount rate capture

1. Time value of money 2. riskiness of cash flows but not all risk is priced and beta tells us the quanity of risk

In March 2004, Fly Paper's stock sold for about $73. Security analysts were forecasting a long-term earnings growth rate of 8.5 percent. The company is expected to pay a dividend of $1.68 per share. Assume dividends are expected to grow along with earnings at g = 8.5 percent per year in perpetuity. What rate of return r were investors expecting?

10.99699%

The Corner Bakery has a debt-equity ratio of 0.62. The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent. What is the pre-tax cost of debt based on M & M Proposition II with no taxes?

11.14%

: EBIT = $25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12% Vl=

161666.67

Required return on assets = 16%; Cost of debt = 10%; Percent of debt = 45%. What is the cost of equity?

20.91%

Winter's Toyland has a debt-equity ratio of 0.65. The pre-tax cost of debt is 8.7 percent and the required return on assets is 16.1 percent. What is the firm's levered cost of equity if you ignore taxes?

20.91%

Sewer's Paradise is an all equity firm that has 5,000 shares of stock outstanding at a market price of $15 a share. The firm's management has decided to issue $30,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 10 percent. How many shares will the firm repurchase? What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes.

2000 shares ebit=7500

Las Paletas Corporation has two different bonds currently outstanding. Bond M has a face value of $20,000 and matures in 20 years. The bond makes no payments for the first six years, then pays $1,100 every six months over the subsequent eight years, and finally pays $1,400 every six months over the last six years. Bond N also has a face value of $20,000 and a maturity of 20 years; it makes no coupon payments over the life of the bond. If the required return on both of these bonds is 6 percent compounded semiannually, what is the current price of bond M? Of bond N?

21913 6131.14

L.A. Clothing has expected earnings before interest and taxes of $48,900, an unlevered cost of capital of 14.5 percent, and a tax rate of 34 percent. The company also has $8,000 of debt 1 that carries a 7 percent coupon. The debt is selling at par value. What is the value of this firm?

225299.31

L.A. Clothing has expected earnings before interest and taxes of $48,900, an unlevered cost of capital of 14.5 percent, and a tax rate of 34 percent. The company also has $8,000 of debt 1 that carries a 7 percent coupon. The debt is selling at par value. What is the value of this firm?

23.20%

Jefferson & Daughter has a levered cost of equity of 14.6 percent and a pre-tax cost of debt of 7.8 percent. Investors would require a return of 13.2 percent if the firm were unlevered. What is the firm's debt-equity ratio based on M & M II with no taxes?

25.93%

Required return on assets = 16%; Cost of debt = 10%; Cost of equity = 25%. What is the Debt-to-Equity ratio?

3/2

Tool Manufacturing has an expected EBIT of $73,000 in perpetuity and a tax rate of 35 percent. The firm has $145,000 in outstanding debt at an interest rate of 7.25 percent, and its unlevered cost of capital is 11 percent. What is the value of the firm? Should the company change its debt-equity ratio if the goal is to maximize the value of the firm?

482114.64 yes, the firm can maximize its taxshield as d/e goes to infinity

Kelso Electric is debating between a leveraged and an unleveraged capital structure. The all equity capital structure would consist of 40,000 shares of stock. The debt and equity option would consist of 25,000 shares of stock plus $280,000 of debt with an interest rate of 7 percent. What is the break-even level of earnings before interest and taxes between these two options? The break-even level of EBIT will occur when EPS for the unlevered firm equals EPS for the levered firm. Ignore taxes.

52266.67

The current dividend yield on Clayton's Metals common stock is 3.2 percent. The company just paid a $1.48 annual dividend and announced plans to pay $1.54 next year. The dividend growth rate is expected to remain constant at the current level. What is the required rate of return on this stock?

7.25% R=(D0/P0)+g

Coccia Co. wants to issue new 20-year bonds for some much-needed expansion projects. The company currently has 8 percent coupon bonds on the market that sell for $1,075, make semiannual payments, and mature in 20 years. What coupon rate should the company set on its new bonds if it wants them to sell at par?

7.28%

Suppose that today you buy an 8 percent annual coupon bond for $1,060. The bond has 19 years to maturity. What rate of return do you expect to earn on your investment? Two years from now, the YTM on your bond has declined by 1 percent, and you decide to sell. What price will your bond sell for? What is the realized return on your investment? Why does the realized return differ from the yield to maturity when you first bought the bond?

7.4% 1162.92 12.12% HPY is greater than the expected YTM when the bond was bought because interest rates dropped by 1 percent; bond prices rise when yields fall.

what is a security

A security, in a financial context, is a certificate or other financial instrument that has monetary value and can be traded. Securities are generally classified as either equity securities, such as stocks and debt securities, such as bonds and debentures.

how does financial leverage change systematic risk

Be=Bu+(1-Tc)D/E(Bu-Bd)

Bond pricing formula

C(1-1/(1+r)^t/r)+FV/(1+r)^t

R=rf+B(rm-rf)

CAPM

what tells us the appropriate discount rate in valuation review

CAPM

CAPM

Capital Asset Pricing Model

Modigliani-miller proposition ii

Cost of Capital is not influence by capital structure but equity risk does increase with debt

Market value of equity

E= number of outstanding shares x market price of one share

What does leverage change

EPS and ROE

. The Veblen Company and the Knight Company are identical in every respect except that Veblen is not levered. Veblen has projected EBIT of $500,000 and a market value of stock of $3.1M. Knight has projected EBIT of $500,000, interest expense of $78,000, market value of stock of $2.05M, and market value of debt of $1.3M. All earnings are in perpetuity, and neither firm pays taxes. Both firms distribute all earnings available to common stockholders immediately. An investor who can borrow at 6 percent per year wishes to purchase 5 percent of Knight's equity. Can he increase his dollar return by purchasing 5 percent of Veblen's equity if he borrows so that the initial net costs of the strategies are the same? Given the two investment strategies, which will the investor choose? When will this process cease?

Let's begin by looking at the big picture. We are in a world without taxes and the two firms differ only by their capital structure. M&M I states that VK should equal VV , however this equality does not hold, VK = 2.05+ 1.3 ̸= 3.1 = VV . It must be the case that some mispricing exists in the equity markets. Can you identify it? First, note that 5% of Knight's equity is $2.05M ×.05 = $102500, while 5% of Veblen's equity is $3.1M×.05 = $155000. In order for the initial costs to be equal, the investor needs to borrow $52500 at 6%. The cash flow from Knight is .05(500000 − 78000) = $21100, while the cash flow from Veblen after the investor's interest expense is .05(500000) − .06(52500) = $21850. The investor will choose the position with the highest cash flow, which is the position in Veblen. This preference will put upward price pressure on Veblen's equity and downward price pressure on Knight's equity until the cash flows (i.e., the returns of the levered and unlevered positions) are equalized.

Annuity formula

P0=C/R(1-1/(1+R)^t)

formula for p0 of a growing perpetuity

Po=CF/(R-g)

cost of capital for an unlevered firm

Ru

Modigliani and Miller Proposition I

Vf not affected by changes in Capital structure; CF don't change therefore valule doesnt

Cavo Corporation expects an EBIT of $19,750 every year forever. The company currently has no debt, and its cost of equity is 15 percent. What is the current value of the company? Suppose the company can borrow at 10 percent. If the corporate tax rate is 35 percent, what will the value of the firm be if the company takes on debt equal to 50 percent of its unlevered value? What if it takes on debt equal to 100 percent of its unlevered value? What will the value of the firm be if the company takes on debt equal to 50 percent of its levered value? What if the company takes on debt equal to 100 percent of its levered value?

Vu=85583 100560 115537 103737 131666

what is the discount rate on the bond

aka cost of debt or yield to maturity

Capital structure

amount of debt and equity a firm uses as its sources of capital

difficulties with stock valuation

cf not known in advance earnings split between reinvestment and dividends and ROR not observable no maturity date

If coupon rate < discount rate, then the bond will sell at a

discount to par

If the coupon rate and the discount rate are equal, then the bond value will

equal par

How can management alter capital structure

increase leverage (increase debt and reduce equity by repurchasing shares (paying a dividend)) or decreasing leverage (retire outstanding debt or issue new equity)

price and discount rate are related how

inversely

when a bond is at par, the cost of debt is equal to

its coupon rate

what are the cash flows of a bond

lump sum repayment of the principal and the annuity consisting of coupon payments

goals of financial management

maximize current market value per share of the existing stock

conflicts of interests

monitoring costs, bonding costs, residual costs

If coupon rate > discount rate, then the bond will sell at a

premium to par

firm value can change because of

riskiness of CF and changing of CF (amouts/timing)

Corporate finance

study of capital budgeting, capital structure, working capital management

Po of cash flows

sum of CF/(1+r)^t

WACC decreases with leverage because

the government subsidizes interest expenses

current yield

y=pmt/p0

Backwater Corp. has 8 percent coupon bonds making annual payments with a YTM of 7.2 percent. The current yield on these bonds is 7.55 percent. How many years do these bonds have left until they mature?

~11 YEARS