Corporate Finance - Problem Set #2
1. [10 points] ABC Corp. is considering expansion of its production capacity by investing in a project with the following unlevered cash flows (UCF):
Year 0: -$20 million
Year 1: +$5 million
Year 2: +$8 million
Year 3 and all future years: +$10 million
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ABC Corp. will finance this expansion both with internal cash and by selling $10 million in bonds. The bonds pay interest of 10%. The expected return on ABC’s stock is 20% and firm is expected to maintain a debt-equity ratio of 1 for the foreseeable future. The corporate income tax rate is 20%. Ignoring the costs of financial distress and issue costs, calculate the net present value of this project using the Flow-To-Equity (FTE) approach.
2. Thani Mint Company has a debt to equity ratio of 0.30. The required return on the company’s unlevered equity is 15 percent, and the pretax cost of the firm’s debt is 9 percent. Sales revenue for the company is expected to remain stable indefinitely at last year’s level of $23,500,000. Variable costs amount to 60 percent of sales. The tax rate is 40 percent and the company distributes all its earnings as dividends at the end of each year.
(a) [7 points] If the company were financed entirely by equity, how much would it be worth?
(b) [8 points] Use the WACC method to calculate the value of the company under the current capital structure.
3. Green Devil Corporation stock, of which you own 100 shares, will pay a $2 per share dividend one year from today. Two years from now Green Devil will close its doors and stockholders will receive a liquidating dividend of $11 per share. The required rate of return on Green Devil stock is 10 percent.
(a) [5 points] What is the current price of Green Devil stock?
(b) [5 points] If you prefer to receive $5 per share dividend (total $500 cash) one year from today, how can you receive the desired amount of cash flow? Explain your strategy.
(c) [10 points] If you prefer to receive equal amounts of money in each of the next two years, how can you accomplish this? Explain your strategy.
4. [15 points] Firm ABC' stock price is currently $100 and there are 1 million shares outstanding. All investors in firm ABC purchased their stock 5 years ago when the price was $50. ABC is sitting on top of $10 million in extra cash that it does not need to fund its operations. With the exception of possible income from this cash, the earnings of ABC are expected to be constant for the foreseeable future. The corporate tax rate is 35%, the personal tax rate on interest income is 30%, and the personal tax rate on dividends and capital gains is 15%. ABC is considering the following options:
(a) Pay the $10 million out in a special dividend today to investors who will invest the cash in T-bills offering an 8% return for the next 5 years.
(b) Pay the $10 million out in the form of a share repurchase today to investors who will invest the cash in T-bills offering an 8% return for the next 5 years
(c) Hold onto the cash and invest it in T-bills offering an 8% return. Pay the cash and interest out to investors in the form of a special dividend after 5 years.
Calculate as of year 5 (i.e., exactly 5 years from today) how much of this $10 million and associated interest ends up in investor's pockets after all taxes under each of the above scenarios.
5. The owner of Gator Airlines wishes to take her firm public by selling 4 million shares. The underwriter determines that the true value will be $12 with probability .3 and $8 with probability .7. There are a group of uninformed investors who are willing to buy 4 million shares as long as they expect not to lose money on average. They also assess the probability of the true value of the shares being $12 with probability .3 and $8 with probability .7. There is a group of informed investors who always know whether the true value is $12 or $8. They are willing to order 2 million shares if the offer price is less than the true value. Assume that if more shares are ordered than are available for sale, the underwriter allocates the available shares on a pro-rata basis based on the size of each groups order (i.e., the fraction of shares a group gets is equal to the groups order/total shares ordered).
(a) [5 points] Calculate the highest offer price at which the entire issue will surely sell.
(b) [5 points] If the stock is sold at the offer price you calculated in (a), could an uniformed investor make money on average by submitting an order to buy some shares of the new issue? Why or why not?
(c) [5 points] If the stock is sold at the offer price you calculated in (a), what will be the expected stock return on its first day of trading?
