BUSS384- Corporate Finance – Problem Set #2 Due by Monday, 24 November, 2014 1. Fun Toy Corporation estimates that there is 25% chance of a recession economy next year, a 50% chance of a normal economy next year, and a 25% chance of a boom economy next year. The corporation will exist until the end of next year and then it will cease to exist. Spartan has $80 of debt that must be repaid next year. Assume a 0% discount rate for all cash flows (in other words, there is no discounting). (a) [5 points] Fun Toy has a low risk project that yields a cash flow of $70 in a recession, $100 in a normal economy, and $130 in a boom. If Fun Toy chooses this low risk project: (i) what is the value of Fun Toy’s debt? (ii) what is the value of Fun Toy’s equity? (b) [5 points] Fun Toy has a high risk project that yields a cash flow of $30 in a recession, $100 in a normal economy, and $160 in a boom. If Fun Toy chooses this high risk project: (i) what is the value of Fun Toy’s debt? (ii) what is the value of Fun Toy’s equity? (c) [5 points] Which project will Fun Toy choose? Given your answers to (a) and (b), when Fun Toy sells the bonds would it like to include a covenant that would prohibit it from taking the high-risk project? Explain your answer. 2. Wolverine Corp. currently has $5,000,000 in equity outstanding and $1,000,000 in debt outstanding. The firm currently has 500,000 shares of common stock outstanding. The firm is contemplating issuing an additional $1,000,000 in debt and using the proceeds to repurchase shares. The corporate tax rate is 40%, the effective personal tax rate on equity income is 10%, and the effective personal tax rate on interest income is 20%. (a) [10 points] What will the firm’s stock price be the moment after the firm announces its refinancing plan? (b) [5 points] Calculate the total market value of the firm’s (i) debt and (ii) equity immediately after the refinancing plan is announced (but before it is actually executed). (c) [5 points] Calculate the total market value of the firm’s (i) debt and (ii) equity after the bond issue and equity repurchase are completed. 3. [15 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 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 (rE) 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. 4. 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) [5 points] If the company were financed entirely by equity, how much would it be worth? (b) [5 points] Calculate WACC of the company under the current capital structure. (b) [5 points] Use the WACC method to calculate the value of the company under the current capital structure. 5. 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. 6. [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.

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