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# CH19 - CHAPTER 19 Financing and Valuation Answers to...

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CHAPTER 19 Financing and Valuation Answers to Practice Questions 1. If the bank debt is treated as permanent financing, the capital structure proportions are: Bank debt (r D = 10 percent) \$280 9.4% Long-term debt (r D = 9 percent) 1800 60.4 Equity (r E = 18 percent, 90 x 10 million shares) 900 30.2 \$2980 100.0% r* = .10(1 - .35).094 + .09(1 - .35).604 + .18(.302) = .096, or 9.6 percent 2. Forecast after-tax incremental cash flows as explained in Section 6-1. Interest is not included—the forecasts assume an all-equity financed firm. 3. Calculate APV by subtracting \$4 million from base-case NPV. 4. We make three adjustments to the balance sheet: - Ignore deferred taxes; these are an accounting entry and represent neither a liability nor a source of funds - “Net out” accounts payable against current assets - Use the market value of equity (7.46 million x \$46) Now the right-hand side of the balance sheet (in thousands) looks like: Short-term debt \$75,600 Long-term debt 208,600 Share holder equity 343,160 Total \$627,360 The after-tax weighted average cost of capital formula, with one element for each source of funding it: r* = r D-ST (1 – T c ) (D-ST / V) + r D-LT (1 – T c ) (D - LT / V) + r E (E / V) r* = .06 (1 - .35) ( 75,600 / 627,360) + .08 (1 - .35) (208,600 / 627,360) + . 15 (343,160 / 627,360) 199

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r* = .004700 + .017290 + .082049 r* = .1040, or 10.40% 5. We use the Miles-Ezzell formula to find r, the opportunity cost of capital: r* = r – L r D T* [ (1 + r) / (1 + r D ) ] Here, we use the following: r* = .1040 L = (75,600 + 208,600) / 627,360 L = .4530 r D = [75,600 / (75,600 + 208,600)] .06 + [208,600 / (75,600 + 208,600)] .08 r D = .0747 Thus, .1040 = r – (.4530) (.0747) (.35) [ (1 + r) / (1.0747) ] r = .1163 If Rensselaer Felts issues \$50 million of new equity and uses the proceeds to retire long-term debt, then short-term debt is unaffected (i.e., remains at \$75,600), the new value for long-term debt is \$158,600, and the new (market) value of equity is \$393,160. If the costs of the debt components are unchanged: r D = [75,600 / (75,6000 + 158,600) ] .06 + [185,600 / (75,600 + 158,600) ] .08 r D = .0735 L = (75,6000 + 158,600) / 627,360 L = .3733 Again, we use the Miles-Ezzell formula: r* = r – L r D T* [ (1 + r) / (1 + r D ) ] r* = .1163 – (.3733) (.0735) (.35) [ (1 + .1163) / (1 + .0735) ] r* = .1063, or 10.63%, a slight increase from 10.40%. 200
Also, r E = r + (r – r D ) (D / E) = .1163 + (.1163 - .0735) (.5957) r E = .1418, or 14.18%, a slight reduction from 15%. 6. Pre-tax operating income \$100.5 Short-term interest 4.5 Long-term interest 16.7 Earnings before tax \$79.3 Tax 27.8 Net income \$51.5 Value of equity = 51.5 / 0.15 = \$343.3 Value of firm = \$343.3 + \$75.6 + \$208.6 = \$627.5 7. The problem here is that issue costs are a one-time correction, while adjusting the WACC implies a correction every year. The only way to account for issue costs in project evaluation is to use the APV formulation and adjust directly by subtracting the issue costs from the base case NPV. 8.

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CH19 - CHAPTER 19 Financing and Valuation Answers to...

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