MGFC10_Chapter18_ClassProblems.pdf - MGFC10H3(Intermediate Finance Class Problems on Valuation and Capital Budgeting for the Levered Firm Instructor

MGFC10_Chapter18_ClassProblems.pdf - MGFC10H3(Intermediate...

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MGFC10H3 (Intermediate Finance) Class Problems on Valuation and Capital Budgeting for the Levered Firm Instructor: Syed W. Ahmed QUESTION 1: Playful Bull Limited has produced rodeo supplies for over 20 years. The company currently has a debt/equity ratio of 45% and is in the 40% tax bracket. The required rate of return on the firm’s levered equity is 15.75%. Playful Bull is planning to expand its production capacity. The equipment to be purchased is expected to generate the following unlevered cash flows: Year 0 1 2 3 Cash Flow -\$27,000,000 9,000,000 15,000,000 12,000,000 The company has arranged a \$14,000,000 debt issue to partially finance the expansion. Under the loan, the company would pay interest of 8.8% at the end of each year on the outstanding balance at the beginning of the year. The company would also make year-end principal payments of \$5,510,000 per year, completely retiring the issue at the end of the 3 rd year. Using the adjusted present value approach, should the company proceed with the expansion? QUESTION 2: Hamilton Beach Corporation’s stock returns have a covariance with the market portfolio of 0.048. The standard deviation of returns on the market portfolio is 20%, and the expected market risk premium is 7.5%. The company has bonds outstanding with a total market value of \$30 million and a yield to maturity of 8%. The company also has 5 million shares of common stock outstanding each selling for \$20. The company’s CEO considers the firm’s current debt/equity ratio optimal. The corporate tax rate

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