Finance Module 4

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk free rate, then the value of the firm's levered equity from the project is closest to:

$10,000 (.5)$90,000 + (05) $117,000 / 1.15= $90,000 $90,000 - $80,000= $10,000

Flagstaff Enterprises expected to have free cash flow in the coming year of $8 million, and this free cash flow is expected to grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and it is in the 35% corporate tax bracket. If Flagstaff currently maintains a .5 debt to equity ratio, then the value of Flagstaff's interest tax shield is closest to:

$11 m rwacc= (E/E+D)rE + (D/E+D)rD x (1-TC) (1/1+.5)x.13 + (.5/1+.5) x .07 x (1-.35)=.101833 VL = FCF/(rE-g) $8/(.101833-.03)=$111.37m PV of tax shield = $11.37

Flagstaff Enterprises expected to have free cash flow in the coming year of $8 million, and this free cash flow is expected to grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and it is in the 35% corporate tax bracket. If Flagstaff currently maintains a .5 debt to equity ratio, then the value of Flagstaff as a levered firm is closest to:

$111 MILLION rwacc= (E/E+D)rE + (D/E+D)rD x (1-TC) (1/1+.5)x.13 + (.5/1+.5) x .07 x (1-.35)=.101833 VL = FCF/(rE-g) $8/(.101833-.03)=$111.37m

If it is managed efficiently, Luther industries will have assets with market value of $100 million, $300, million, or $500 million next year, with each outcome being equally likely. Managers may, however, engage in wasteful empire building which will reduce the firm's market value by $20 million in all cases. Managers may also increase the risk of the firm, changing the probability of each outcome to 50%, 20%, and 30% respectively. If its managers engage in empire building, then the expected market value of Luther's assets is closest to:

$280 million 1/3 x 80 + 1/3 x 280 + 1/3 x 480 = 280 million

If it is managed efficiently, Luther industries will have assets with market value of $100 million, $300, million, or $500 million next year, with each outcome being equally likely. Managers may, however, engage in wasteful empire building which will reduce the firm's market value by $20 million in all cases. Managers may also increase the risk of the firm, changing the probability of each outcome to 50%, 20%, and 30% respectively. If it is managed efficiently, then the expected market value of Luther's assets is closest to:

$300 million 1/3 x 100 + 1/3 x 300 + 1/3 x 500 = 300 million

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk free rate, then the cash flow that equity holders will receive in one year in a strong economy is closest to:

$33,000 $117,000-$80,000 (1.05)=$33,000

Rosewood Industries has EBIT of $450 million, interest expense of $175 million, and a corporate tax rate of 35%. The total of Rosewood's net income and interest payments is closest to:

$355 M Net income + Interest expense = (EBIT - Interest expense)(1 - τC)= (450 - 175)(1 - .35) = $178.75 + $175 = $353.73

Wyatt Oil issued $100 million in perpetual debt (at par) with an annual coupon of 7%. Wyatt will pay interest only on this debt. Wyatt's marginal tax rate is expected to be 40% for the foreseeable future. The present value of Wyatt's annual interest tax shield is closest to:

$40 million PV Tax Shield = (Debt x Interest Rate x Tax Rate)/ Discount Rate

Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%. According to MM Proposition 1, the stock price for With is closest to:

$6.00 Under MM I, the total value of With and Without must be the same. Value(Without) = 1,000,000 × $24 = $24 million Value(levered equity) = value(With) - debt = $24 M - $12M = $12 M Price Per Share = 12m/2m = $6.00

Rosewood Industries has EBIT of $450 million, interest expense of $175 million, and a corporate tax rate of 35%. The amount of Rosewood's interest tax shield is closest to:

$61 million Interest expense x (τC) = 175(.35) = $61.25

With its current leverage, WELS Corporation will have Free Cash Flow of $4 million. If WELS corporate tax rate is 35% and it pays 8% interest on its debt, how much is the maximum additional debt can WELS issue this year and still receive the benefit of the interest tax shield next year?

%50 m Divide FCF by the interest rate to calculate the amount of debt that could be issued: 4,000,000/.08 = $50,000,000 in new debt

Flagstaff Enterprises expected to have free cash flow in the coming year of $8 million, and this free cash flow is expected to grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and it is in the 35% corporate tax bracket. If Flagstaff maintains a debt to equity ratio of 1, then Flagstaff's pre-tax WACC is closest to:

10% rwacc = E/(E+D) rE + D(E+D) rD 1/(1+1) x .13 + 1/(1+1) x.07 = .10

Suppose that Taggart Transcontinental currently has no debt and has an equity cost of capital of 10%. Taggart is considering borrowing funds at a cost of 6% and using these funds to repurchase existing shares of stock. Assume perfect capital markets. If Taggart borrows until they achieved a debt-to-value ratio of 20%, then Taggart's levered cost of equity would be closest to:

11% re=ru+d/e(ru-rd) 10%+20%/80%(20%-6%)=11%

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. The equity holders will receive the cash flows of the project in one year. The market value of the unlevered equity for this project is closest to:

90,000 PV (equity cash flows) = (.5)90,000 + (.5) 117,000/1.15

According to the provisions of the 1978 Bankruptcy Reform Act, U.S. firms can file for two forms of bankruptcy protection: Chapter 11 or Chapter 13. True or False

False

Although indirect costs of bankruptcy are difficult to measure accurately, they are typically much smaller than the direct costs of bankruptcy. True or False

False

At high levels of debt, the risk of default remains low and the main effect of an increase in leverage is an increase in the interest tax shield, which has present value t*D, where t* is the effective tax advantage of debt. True or False

False

By increasing the amount paid to debt holders through interest payments, the amount of the pre-tax cash flows that must be paid as taxes increases. True or False

False

If bankruptcy is costly, these costs will increase the tax advantages of debt financing. True or False

False

In the Chapter 7 bankruptcy, all pending collection attempts are automatically suspended, and the firm's existing management is given the opportunity to propose a reorganization plan. True or False

False

Real estate firms are likely to have high costs of financial distress, as much of their value derives from assets that can be sold relatively easily. True or False

False

The costs of financial distress reduce the value of the levered firm, VL. The amount of the reduction decreases with the probability of default, which in turn increases with the level of the debt D. True or False

False

The data show a clear preference for equity as a source of external financing for the total population of U.S. firms. True or False

False

The total value of the unlevered firm exceeds the value of the firm with leverage due to the present value of the tax savings from debt. True or False

False

The tradeoff theory weighs the costs of debt that result from shielding cash flows from taxes against the benefits from the effects of financial distress associated with leverage. True or False

False

To receive the full tax benefits of leverage a firm needs to use 100% debt financing. True or False

False

When a firm faces financial distress, creditors can gain by making sufficiently risky investments, even if they have negative NPV. True or False

False

When a firm fails to make a required payment to debt holders, it is in bankruptcy. True or False

False

Whether default occurs depends on the cash flows, not on the relative values of the firm's assets and liabilities. True or False

False

Whether paid by the firm or its creditors, the indirect costs of bankruptcy increase the value of the assets that the firm's investors will ultimately receive. True or False

False

While developing a Chapter 11 reorganization plan, management ceases to operate the business. True or False

False

Which of the following statements is/are FALSE? I) Leverage decreases the risk of the equity of a firm. II) Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price the combined values of debt and equity must be equal to the cash flows of the project. III) Franco Modigliani and Merton Miller argued that with perfect capital markets, the total value of a firm depends on its capital structure.

I and III only

Which of the following is NOT one of Modigliani and Miller's set of conditions referred to as perfect capital markets? I) All investors hold the market portfolio. II) There are no taxes, transaction costs, or issuance costs associated with security trading. III) A firm's financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them. IV) Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

I only

Which of the following statements is/are TRUE? I) Firms with high R&D costs and future growth opportunities typically maintain high debt levels. II) The tradeoff theory explains how firms should choose their capital structures to maximize value to current shareholders. III) With tangible assets, the financial distress costs of leverage are likely to be low, as the assets can be liquidated for close to their full value. IV) Proponents of the management entrenchment theory of capital structure believe that managers choose a capital structure to avoid the discipline of debt and maintain their own job security.

II, III and IV only

According to the tradeoff theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs. True or False

True

Agency costs are costs that arise when there are conflicts of interest between stakeholders. True or False

True

An important consequence of leverage is the risk of bankruptcy. True or Fasle

True

Aside from the direct legal and administrative costs of bankruptcy, many other indirect costs are associated with financial distress (whether or not the firm has formally filed for bankruptcy). True or False

True

Bankruptcy is a long and complicated process that imposes both direct and indirect costs on the firm and its investors that the assumption of perfect capital markets ignores. True or False

True

Bankruptcy is rarely simple and straightforward-equity holders don't just "hand the keys" to debt holders the moment the firm defaults on a debt payment. True or False

True

Bankruptcy protection can be used by management to delay the liquidation of a firm that should be shut down. True or False

True

Because Corporations pay taxes on their profits after interest payments are deducted, interest expenses reduce the amount of corporate tax firms must pay. True or False

True

Because many aspects of the bankruptcy process are independent of the size of the firm, the costs are typically higher, in percentage terms, for smaller firms. True or False

True

Because the cash flows of the levered firm are equal to the sum of the cash flows from the unlevered firm plus the interest tax shield, by the Law of One Price the same must be true for the present values of these cash flows. True or False

True

Capital expenditures greatly exceed firms' external financing, implying that most investment and growth is supported by internally generated funds, such as retained earnings. True or False

True

Debt as a fraction of firm value has varied in a range from 30-45% for the average firm. True or False

True

Economic distress is a significant decline in the value of a firm's assets, whether or not it experiences financial distress due to leverage. True or False

True

Firms have an incentive to increase leverage to exploit the tax benefits of debt. But with too much debt, they are more likely to risk default and incur financial distress costs. True or False

True

Firms in growth industries like biotechnology or high technology carry very little debt, whereas airlines, auto makers, utilities, and financial firms have high leverage ratios. True or False

True

Firms whose value and cash flows are very volatile (for example, semiconductor firms) must have much lower levels of debt to avoid a significant risk of default. True or False

True

Firms with steady, reliable cash flows, such as utility companies, are able to use high levels of debt and still have a very low probability of default. True or False

True

Given a forecast of future interest payments, we can determine the interest tax shield and compute its present value by discounting it at a rate that corresponds to its risk. True or False

True

If there were no costs of financial distress, the value of the firm would continue to increase with increasing debt until the interest on the debt exceeds the firm's earnings before interest and taxes and the tax shield is exhausted. True or False

True

In addition to the money spent by the firm, the creditors may incur costs during the bankruptcy process. True or False

True

In general, the gain to investors from the tax deductibility of interest payments is referred to as the interest tax shield. True or False

True

In some circumstances, managers may take actions that benefit shareholders but harm the firm's creditors and lower the total value of the firm. True or False

True

Leverage has costs as well as benefits. True or False

True

Modigliani and Miller's results continue to hold in a perfect market even when debt is risky and the firm may default. True or False

True

The Chapter 11 reorganization plan specifies the treatment of each creditor of the firm. In addition to cash payment, creditors may receive new debt or equity securities of the firm. The value of cash and securities is generally less than the amount each creditor is owed, but more than the creditors would receive if the firm were shut down immediately and liquidated. True or False

True

The bankruptcy code is designed to provide an orderly process for settling a firm's debts. True or False

True

The interest tax shield is the additional amount that a firm would have paid in taxes if it did not have leverage. True or False

True

The tradeoff theory states that firms should increase their leverage until it reaches the level D* for which VL is maximized. True or False

True

There is an important tax advantage to the use of debt financing. True or False

True

To compute the increase in the firm's total value associated with the interest tax shield, we need to forecast a firm's debt and its interest payments. True or False

True

To determine the benefit of leverage for the value of the firm, we must compute the present value of the stream of future interest tax shields the firm will receive. True or False

True

To ensure that their rights and interests are respected, and to assist in valuing their claims in a proposed reorganization, creditors may seek separate legal representation and professional advice. True or False

True

When a firm has leverage, a conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt. True or False

True

When a firm uses debt, the interest tax shield provides a corporate tax benefit each year.

True

While firms seem to prefer debt when raising external funds, not all investment is externally funded. True or False

True

With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt-bankruptcy simply shifts the ownership of the firm from equity holders to debt holders without changing the total value available to all investors. True or False

True

Which of the following is NOT a direct cost of bankruptcy? a. Costs to creditors b. Investment banking costs c. Costs of accounting experts d. Legal costs and fees

a. Costs to creditors

Which of the following statements is FALSE? a. Modigliani and Miller's conclusion verified the common view, which stated that even with perfect capital markets, leverage would affect a firm's value. b. We can evaluate the relationship risk and return more formally by computing the sensitivity of each security's return to the systematic risk of the economy c. Investors in levered equity require higher expected return to compensate for its increased risk. d. Leverage increases the risk of equity even when there is not risk that the firm will default.

a. Modigliani and Miller's conclusion verified the common view, which stated that even with perfect capital markets, leverage would affect a firm's value.

Which of the following statements is false? a. The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions. b. In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security holders is equal to the total cash flow generated by the firm's assets. c. With perfect capital markets, leverage merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of the firm. d. In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

a. The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions.

In an agency problem known as asset substitution, the agency cost is paid by: a. the debt holders, since if the risky project is not successful debt holders will lose all their money. b. the debt holders, since if the risky project is successful debt holders will receive less money. c. the equity holders, since the strategy has a negative expected payoff. d. the equity holders, since they will lose all their money whether or not the project is successful.

a. the debt holders, since if the risky project is not successful debt holders will lose all their money.

Which of the following statements is TRUE? a. The agency costs of debt can arise only if there is no chance the firm will default and impose losses on its debt holders. b. Agency costs represent another cost of increasing the firm's leverage that will affect the firm's optimal capital structure choice. c. An over-investment problem occurs when shareholders choose to not invest in a positive-NPV project. d. When a firm faces financial distress, there will be no conflict of interest between shareholders and debtholders.

b. Agency costs represent another cost of increasing the firm's leverage that will affect the firm's optimal capital structure choice.

Which of the following statements is FALSE? a. With no debt, the WACC is equal to the unlevered equity cost of capital. b. With perfect capital markets, a firm's WACC is dependent of its capital structure and is equal to its equity cost of capital only the firm it is unlevered. c. As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the net effect is that the firm's WACC is unchanged. d. Although debt has a lower cost of capital than equity, leverage does not lower a firm's WACC.

b. With perfect capital markets, a firm's WACC is dependent of its capital structure and is equal to its equity cost of capital only the firm it is unlevered.

A type of agency problem that results in shareholders gaining by choosing not to finance new, positive-NPV projects is: a. asset substitution. b. debt overhang. c. excessive risk-taking. d. distress costs.

b. debt overhang.

Which of the following statements is FALSE? a. Leverage can reduce the degree of managerial entrenchment because managers are more likely to be fired when a firm faces financial distress. b. When a firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight. c. According to the empire building hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers. d. Managers of large firms tend to earn higher salaries, and they may also have more prestige and garner greater publicity than managers of small firms. As a result, managers may expand (or fail to shut down) unprofitable divisions, pay too much for acquisitions, make unnecessary capital expenditures, or hire unnecessary employees.

c. According to the empire building hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers.

Which of the following is one unintended consequence of the federal bailouts in response to the 2008 financial crisis? a. Bondholders will charge equity holders for the risk of this abuse. b. Equity holders will credibly commit not to take excessive risk by agreeing to very strong bond covenants. c. Lenders to corporations considered "too big to fail" may presume they have an implicit government guarantee, thus lowering their incentives to insist on strong covenants. d. Managers who earned large bonuses when their businesses did well did not need to repay those bonuses later when things turned sour.

c. Lenders to corporations considered "too big to fail" may presume they have an implicit government guarantee, thus lowering their incentives to insist on strong covenants.

d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $200 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect. Suppose you are a shareholder in d'Anconia Copper holding 300 shares, and you disagree with the decision to lever the firm. You can undo the effect of this decision by: a. borrowing $2000 and buying 100 shares of stock. b. selling 100 shares of stock and lending $2000. c. borrowing $1200 and buying 60 shares of stock. d. selling 60 shares of stock and lending $1200.

d. selling 60 shares of stock and lending $1200. After leveraging d'ansonia Copper has debt $200 million and equity $800 million (60 x 20 million - $400 repurchased). So its debt weight = .20 → for every $1 invested you need $0.80 in equity and $0.20 in debt. Pre levering your portfolio consisted of 300 shares × $20 = $6000 in stock. Of this you need to sell 20% to reinvest into bonds so you need to sell ($6000 × .2 = $1200/$20 per share =) 60 shares of stock and then lend this money out. In that way, you achieved homemade deleveraging.

Consider the following formula: V = V + τ D The term τ D represents:

the interest tax shield each year.

Equity in a firm with no debt is called:

unlevered equity