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Debt payments $ 100,000 (All Interest payments)

Taxable Income $ 500,000

Tax $ 200,000

After-tax profit $ 300,000

If this project requires an investment of $ 3,000,000, what is its NPV?

7. UB Inc. is examining its capital structure, with the intent of arriving at an optimal debt

ratio. It currently has no debt and has a beta of 1.5. The riskless interest rate is 9%. Your

research indicates that the debt rating will be as follows at different debt levels:

D/(D+E) Rating Interest rate

0% AAA 10%

10% AA 10.5%

20% A 11%

30% BBB 12%

40% BB 13%

50% B 14%

60% CCC 16%

70% CC 18%

80% C 20%

90% D 25%

The firm currently has 1 million shares outstanding at $ 20 per share (tax rate = 40%).

a. What is the firm's optimal debt ratio?

b. Assuming that the firm restructures by repurchasing stock with debt, what will the

value of the stock be after the restructuring?

8. GenCorp, an automorive parts manufacturer, currently has $25 million in outstanding debt and

has 10 million shares outstanding. The book value per share is $10, while the market value is $

25. The company is currently rated A, its bonds have a yield to maturity of 10%, and the current

beta of the stock is 1.06. The six-month T.Bill rate is 8% now, and the company's tax is 40%.

a. What is the company's current weighted average cost of capital?

b. The company is considering a repurchase of 4 million shares at $25 per share with new

debt. It is estimated that this will push the company's rating down to a B (with a yield to

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maturity of 13%). What will the company's weighted average cost of capital be after the

stock repurchase?

9. You have been called in as a consultant for Herbertâ€™s Inc., a sporting good retail firm, which

is examining its debt policy. The firm currently has a balance sheet as follows:

Liability Assets

LT Bonds $100 Fixed Assets 300

Equity $300 Current Assets 100

Total $400 Total 400

The firm's income statement is as follows:

Revenues 250

COGS 175

Depreciation 25

EBIT 50

LT Interest 10

EBT 40

Taxes 16

Net Income 24

The firm currently has 100 shares outstanding, selling at a market price of $5 per share and the

bonds are selling at par. The firm's current beta is 1.12, and the six-month T.Bill rate is 7%.

a. What is the firm's current cost of equity?

b. What is the firm's current cost of debt?

c. What is the firm's current weighted average cost of capital?

Assume that management of Herbertâ€™s Inc. is considering doing a debt-equity swap (i.e.

borrowing enough money to buy back 70 shares of stock at $5 per share). It is believed that this

swap will lower the firm's rating to C and raise the interest rate on the company's debt to 15%.

d. What is the firm's new cost of equity?

e. What is the effective tax rate (for calculating the after-tax cost of debt) after the swap?

f. What is the firm's new cost of capital?

11. Terck Inc., a leading pharmaceutical company, currently has a balance sheet that is as

follows:

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Liability Assets

LT Bonds $1000 Fixed Assets 1700

Equity $1000 Current Assets 300

Total $1000 Total 1000

The firm's income statement looks as follows:

Revenues 1000

COGS 400

Depreciation 100

EBIT 500

LT Interest 100

EBT 400

Taxes 200

Net Income 200

The firm's bonds are all 20-year bonds with a coupon rate of 10% which are selling at 90% of

face value (the yield to maturity on these bonds is 11%). The stocks are selling at a PE ratio of 9

and have a beta of 1.25. The six-month T.Bill rate is 6%.

a. What is the firm's current cost of equity?

b. What is the firm's current after-tax cost of debt?

c. What is the firm's current weighted average cost of capital?

Assume that management of Terck Inc., which is very conservative, is considering doing an

equity-for-debt swap (i.e. issuing $200 more of equity to retire $200 of debt). This action is

expected to lower the firm's interest rate by 1%.

d. What is the firm's new cost of equity?

e. What is the new WACC?

f. What will the value of the firm be after the swap?

11. You have been asked to analyze the capital structure of DASA Inc, an environmental waste

disposal firm, and make recommendations on a future course of action. DASA Inc. has 40

million shares outstanding, selling at $20 per share, and a debt-equity ratio (in market value

terms) of 0.25. The beta of the stock is 1.15, and the firm currently has a AA rating, with a

corresponding market interest rate of 10%. The firm's income statement is as follows:

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EBIT $150 million

Interest Exp. $ 20 million

Taxable Inc. $130 million

Taxes $ 52 million

Net Income $ 78 million

The current T.Bill rate is 8%.

a. What is the firm's current weighted average cost of capital?

b. The firm is proposing borrowing an additional $200 million in debt and repurchasing

stock. If it does so, its rating will decline to A, with a market interest rate of 11%. What

will the weighted average cost of capital be if they make this move?

c. What will the new stock price be if the firm borrows $200 million and repurchases

stock (assuming rational investors)?

d. Now assume that the firm has another option to raise its debt/equity ratio (instead of

borrowing money and repurchasing stock). It has considerable capital expenditures

planned for the next year ($150 million). The company also currently pays $1 in

dividends per share. If the company finances all its capital expenditures with debt and

doubles its dividend yield from the current level for the next year, what would you

expect the debt/equity ratio to be at the end of the next year.

12. You have been asked by JJ Corporation, a California-based firm that manufacturers

and services digital satellite television systems, to evaluate its capital structure. They

currently have 70 million shares outstanding trading at $10 per share. In addition, it has

500,000 convertible bonds, with a coupon rate of 8%, trading at $ 1000 per bond. JJ

Corporation is rated BBB and the interest rate on BBB straight bonds is currently 10%.

The beta for the company is 1.2, and the current risk-free rate is 6%. The tax rate is 40%.

a. What is the firm's current debt/equity ratio?

b. What is the firm's current weighted average cost of capital?

JJ Corporation is proposing to borrow $250 million and use it for the following purposes:

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Buy back $100 million worth of stock

Pay $100 million in dividends

Invest $ 50 million in a project with a NPV of $25 million.

The effect of this additional borrowing will be a drop in the bond rating to B, which

currently carries an interest rate of 11%.

c. What will the firm's cost of equity be after this additional borrowing?

d. What will the firm's weighted average cost of capital be after this additional

borrowing?

e. What will the value of the firm be after this additional borrowing?

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13. Baldor Electric, a company which gets 85% of its revenues from industrial electric

motors, had 27.5 million shares at $ 25 per share, and $ 25 million in debt outstanding at

the end of 1995. The firm has a beta of 0.70, had earnings before interest and taxes of

$63.3 million and a book value of equity of $200 million. The following table

summarizes the ratings and interest rates for Baldor Electric at different levels of debt.

Debt Ratio Bond Rating Interest Rate on Debt

0% AA 6.70%

10% A+ 7.00%

20% A- 7.50%

30% BBB 8.00%

40% BB 8.50%

50% B+ 9.00%

60% B 10.00%

70% B- 11.00%

80% CCC 12.00%

90% C 15.00%

The tax rate is 35%.

a. Estimate the cost of equity at each level of debt.

b. Estimate the return on equity at each level of debt.

c. Estimate the optimal debt ratio based upon the differential return.

d. Will the value of the firm be maximized at this level of debt. Why or why not?

14. Pfizer, one of the largest pharmaceutical companies in the United States, is

considering what its debt capacity is. In March 1995, Pfizer had an outstanding market

value of equity of $ 24.27 billion, debt of $ 2.8 billion and a AAA rating. Its beta was

1.47, and it faced a marginal corporate tax rate of 40%. The treasury bond rate at the time

of the analysis was 6.50%, and AAA bonds trade at a spread of 0.30% over the treasury

rate.

a. Estimate the current cost of capital for Pfizer.

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b. It is estimated that Pfizer will have a BBB rating if it moves to a 30% debt ratio, and

that BBB bonds have a spread of 2% over the treasury rate. Estimate the cost of capital if

Pfizer moves to its optimal.

c. Assuming a constant growth rate of 6% in the firm value, how much will firm value

change if Pfizer moves its optimal? What will the effect be on the stock price?

d. Pfizer has considerable research and development expenses. Will this fact affect

whether Pfizer takes on the additional debt?

15. Upjohn, another major pharmaceutical company, is also considering whether it should

borrow more. It has $ 664 million in book value of debt outstanding, and 173 million

shares outstanding at $ 30.75 per share. The company has a beta of 1.17, and faces a tax

rate of 36%. The treasury bond rate is 6.50%.

a. If the interest expense on the debt is $ 55 million, the debt has an average maturity of

10 years, and the company is currently rated AA- (with a market interest rate of 7.50%),

estimate the market value of the debt.

b. Estimate the current cost of capital.

c. It is estimated that if Upjohn moves to its optimal debt ratio, and no growth in firm

value is assumed, the value per share will increase by $ 1.25. Estimate the cost of capital

at the optimal debt ratio.

16. Nucor, an innovative steel company, has had a history of technical innovation and

financial conservatism. In 1995, Nucor had only $ 210 million in debt outstanding (book

as well as market value), and $ 4.2 billion in market value of equity (with a book value of

$ 1.25 billion). In the same year, Nucor had earnings before interest and taxes of $ 372

million, and faced a corporate tax rate of 36%. The beta of the stock is 0.75, and the

company is AAA rated (with a market interest rate of 6.80%).

a. Estimate the return differential between return on equity and cost of equity at the

current level of debt.

b. Estimate the return differential at a debt ratio of 30%, assuming that the bond rating

will drop to A-, leading to market interest rate of 8.00%.

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17. Bethlehem Steel, one of the oldest and largest steel companies in the United States, is

considering the question of whether it has any excess debt capacity. The firm has $ 527

million in market value of debt outstanding, and $ 1.76 billion in market value of equity.

The firm has earnings before interest and taxes of $ 131 million, and faces a corporate tax

rate of 36%. The companyâ€™s bonds are rated BBB, and the cost of debt is 8%. At this

rating, the firm has a probability of default of 2.30%, and the cost of bankruptcy is

expected to be 30% of firm value.

a. Estimate the unlevered value of the firm.

b. Estimate the levered value of the firm, using the adjusted present value approach, at a

debt ratio of 50%. At that debt ratio, the firmâ€™s bond rating will be CCC, and the

probability of default will increase to 46.61%.

18. Kansas City Southern, a railroad company, had debt outstanding of $ 985 million and

40 million shares trading at $ 46.25 per share in March 1995. It earned $ 203 million in

earnings before interest and taxes, and faced a marginal tax rate of 36.56%. The firm was

interested in estimating its optimal leverage using the adjusted present value approach.

The following table summarizes the estimated bond ratings, and probabilities of default at

each level of debt from 0% to 90%.

Debt Ratio Bond Rating Probability of Default

0% AAA 0.28%

10% AAA 0.28%

20% A- 1.41%

30% BB 12.20%

40% B- 32.50%

50% CCC 46.61%

60% CC 65.00%

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