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18-08-2018

Product code: Accounts-AW306

. Answer the following questions pertaining to cost of capital and capital budgeting.

(a) Consider a _rm whose common stock has a CAPM beta of 1.2. The risk-free rate is 4.5 percent and the expected return on the market portfolio is 13 percent.

(i) What is the _rm's equity capital?

(ii) Suppose that the _rm has an outstanding debt issue with 12 years to maturity and is priced at 105 percent of face value. The bond issue makes payments semi annually and pays an annual coupon rate of 8 percent. What is the _rm's pretax cost of debt? (Hint: What is the discount rate that correctly prices the _rm's debt?)

(iii) If the _rm is in the 35 percent corporate tax bracket, what is its aftertax cost of debt?

(iv) The _rm's debt-equity ratio is 0.40. What is its weighted average cost of capital?

(v) Now suppose that the _rm has a potential project in which it can invest. The project is

expected to earn cash ows of \$10,000 over each of the next _ve years. If this project is of

equal risk with the _rm's current projects, calculate its NPV. Should the _rm accept or reject

the proposed project?

(b) Consider a _rm with a weighted average cost of capital equal to 12 percent. This _rm's cost of debt is 10 percent and its cost of equity capital is 16.5 percent. If the corporate tax rate is 35 percent, calculate the _rm's debt-equity ratio.

(c) An all-equity _rm is considering the following projects:

Project Beta Expected return

A 0.60 11%

B 0.90 13%

C 1.20 14%

D 1.70 16%

Suppose that the rate of return on T-bills is 6 percent and the expected rate of return on the

S&P500 is 13 percent. Further suppose that the _rm has a 12 percent cost of capital

(i) Which projects have a higher expected return than the _rm's cost of capital?

(ii) Which projects should the _rm accept (i.e., which projects are positive NPV)?

(iii) Which projects would be incorrectly accepted or rejected if the _rm's overall cost of capital

were used as a hurdle rate?

2. Answer the following questions pertaining to capital structure.

(a) Consider an all-equity _rm with a total market value of \$150,000. Earnings before interest and taxes (EBIT) are projected to be \$14,000 under normal economic circumstances. If the economy slumps into a recession, EBIT will be 60% lower; if the economy enters a period of expansion, EBIT will be 35% higher. Each of these scenarios is deemed equally likely. The _rm is considering a plan to issue \$60,000 in debt with a 5 percent rate of interest and will use the proceeds to repurchase shares of its stock. There are currently 2,500 shares outstanding. Ignore taxes.

(i) Calculate earnings per share (EPS) under each of these three economic scenarios if the _rm does not go through with the proposed plan.

(ii) Repeat part (i) above assuming that the _rm does go through with the proposed plan.

(iii) What do you observe?

(b) Repeat all parts of (a) above assuming that there is a corporate tax rate of 35 percent.

(c) Consider a _rm whose equity multiplier is equal to 2.50. Its WACC is 12 percent and its cost of debt is 14 percent. The _rm is in the 35 percent corporate tax bracket.

(i) What is the _rm's cost of equity capital?

(ii) What would be the _rm's cost of capital if it were unlevered?

(iii) What would be the _rm's cost of equity capital if its equity multiplier increased to 3.00?

What if it decreased to 1.00?

(d) Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures (as their names suggest). Each company expects to earn \$96 million before interest per year in perpetuity, with each company distributing all its earnings as dividends. Levered's perpetual debt has a market value of \$275 million and the _rm pays 8 percent interest on this debt each year, and it currently has 4.5 million shares outstanding worth \$100 per share. On the other hand, Unlevered has no debt and has 10 million shares outstanding worth \$80 per share. Neither _rm pays taxes. Is Levered's stock a better buy than Unlevered's stock?

(e) An all-equity _rm is considering a loan of \$1 million, which it will repay in equal installments over the next two years at an interest rate of 8 percent. The company's tax rate is 35 percent. According to Modigliani-Miller Proposition 1 (with corporate taxes), what would be the increase in the value of the company after the loan? (Hint: Modigliani-Miller Proposition 1 states VL = VU + tC _ B. We referred to this last term as the \\present value of the annual tax shield.")

The analysis in i) & ii) above shows that debt magnifies risks as in recession condition the EPS is much lower in scenario ii compare to scenario i. However at the same time it improves the return significantly as we saw in normal and recession conditions where EPS is higher in scenario ii compare to scenario i.

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