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Assignment 1 - Fin 645

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14 views5 pages

Assignment 1 - Fin 645

Uploaded by

Ushanthini Nithanthan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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FIN 643 Corporate Financial Policy

(Spring 2024) Online


Assignment 1

Question 1 (10 Points)


Brannan Manufacturing has a target debt-equity ratio of .35. Its cost of equity is 12.6 percent,
and its pretax cost of debt is 7.3 percent. If the tax rate is 21 percent, what is the company’s
WACC?

D: E 0.35
S/(S+B) 1/ (1.35) 0.741
B/(S+B) 0.259
RS 12.60% 0.126
RB(pre-tax) 7.30% 0.073
Tc 21% 0.210

WACC (0.741 * 0.126) + (0.259*0.073(1 - 0.210)


(0.741 * 0.126) + (0.259*0.073*0.79)
0.108
10.83%

Question 2 (10 Points)


Fama’s Llamas has a weighted average cost of capital of 9.9 percent. The company’s cost of
equity is 13.5 percent, and its pre-tax cost of debt is 8.1 percent. The tax rate is 24 percent.
What is the company’s debt-equity ratio?

D: E 0.9616 1.9616
S/(S+B) 1/ (1.9616) 0.510
B/(S+B) 0.490
Rs 13.50% 0.135
Rd(pre-tax) 8.10% 0.081
Tc 24% 0.240

WACC (0.510 * 0.135) + (0.490*0.081*(1-0.24)


(0.510 * 0.135) + (0.490*0.081*0.76)
0.099
9.90%
Debt to Equity Ratio = 0.96
Question 3 (20 Points)
Dani Corporation has 7 million shares of common stock outstanding. The current share price
is $67, and the book value per share is $6. The company also has two bond issues
outstanding. The first bond issue has a face value of $60 million, a coupon rate of 7 percent,
and sells for 92 percent of par. The second issue has a face value of $45 million, a coupon
rate of 6 percent, and sells for 104 percent of par. The first issue matures in 22 years, the
second in 7 years. Suppose the most recent dividend was $4.15 and the dividend growth rate
is 4.2 percent. Assume that the overall cost of debt is the weighted average of that implied by
the two outstanding debt issues. The tax rate is 23 percent. What is the company’s WACC?
(Hint: You will need to find the yield to maturity (YTM) of each bond assuming semi-annual.
coupon pay-out, see textbook Chapter 8; You can also safely assume the par value of the
bonds are close enough to their market value)

Weighted
Details Number of Shares Price/Share Total Value Weight Cost Cost
Equity 7,000,000 67 469,000,000 82.14% 10.65% 8.75%
First bond value 60,000,000 92% 55,200,000 9.67% 5.98% 0.58%
Second Bond
Value 45,000,000 104% 46,800,000 8.20% 4.08% 0.33%
571,000,000 WACC 9.66%

Share cost Dividend * (1 + Growth


= %) + Growth%
Price
$4.15*(1+ 4.2%) +4.2%
67
0.1065
10.65%
Question 4 (30 Points)
Foundation Corporation is comparing two different capital structures, an all-equity plan (Plan
I) and a levered plan (Plan II). Under Plan I, the company would have 195,000 shares of
stock outstanding. Under Plan II, there would be 145,000 shares of stock outstanding and
$2.1 million in debt outstanding. The interest rate on the debt is 8 percent and there are no
taxes.
Answer the followings:
a. If EBIT is $550,000, what is the earnings per share (EPS = Net income/no. of shares)
for each plan?

Plan 1 Plan 2
Shares 195,000 145,000
Debt 2,100,000
EBIT 550,000 550,000
Interest 0 168,000
Net profit 550,000 382,000
EPS 2.82 2.63

b. If EBIT is $800,000, what is the EPS for each plan?

Plan 1 Plan 2
Shares 195,000 145,000
Debt 2,100,000
EBIT 800,000 800,000
Interest 0 168,000
Net profit 800,000 632,000
EPS 4.10 4.36

c. What is the break-even EBIT?


(Hints: To find EPS, you need to calculate Net Income from EBIT)

Plan 1 = Plan 2
EPS EBIT/195,000 = (EBIT-168000)/145,000
145,000EBIT = 195,000EBIT-32,760,000,000
50,000EBIT = 32,760,000,000
EBIT = 655,200
Question 5 (10 Points)
Foundation Corporation is comparing two different capital structures, an all-equity plan (Plan
I) and a levered plan (Plan II). Under Plan I, the company would have 205,000 shares of
stock outstanding. Under Plan II, there would be 155,000 shares of stock outstanding and
$2.17 million in debt outstanding. The interest rate on the debt is 6 percent and there are no
taxes. What is the value of the firm under each of the two proposed plans?

Plan 1 Plan 2
Shares 205,000 155,000
Share Price 43.4 43.4 Assumption- Equal Firm value
Equity 8,897,000 6,727,000
Debt 0 2,170,000
Value of the firm 8,897,000 8,897,000 Equity + Debt

Question 6 (20 Points)


Good Time Company is a regional chain department store. It will remain in business for one
more year. The probability of a boom year is 70 percent, and the probability of a recession is
30 percent. It is projected that the company will generate a total cash flow of $187 million in
a boom year and $78 million in a recession. The company's required debt payment at the end
of the year is $112 million. The market value of the company’s outstanding debt is $85
million. The company pays no taxes.
a. What payoff do bondholders expect to receive in the event of a recession?

Bondholders will receive their share on a priority basis in the event of a recession as
bondholder payments are mandatory for a corporation and are considered differently from
equity holders. As a result, bond holders will get a pay-out of $78 million in the event of a
recession.

b. What are the promised and expected returns on the company's debt to the bondholders.
respectively?

Promised Return on Debt. = Promised Amount -1


= Current market Value
= (112/85)-1
= 31.76%
In the event of a boom, the projected return is 31.76%, which is also the realised return.
When there is a recession:

Realized return = Payment to debt holders -1


Current market Value
= (78/85)-1
= -8.24%

Expected return = (31.76*70%) + (-8,24*30%)


= 0.1976
= 19.76%

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