S11 - HASS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT...

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H ASS S CHOOL OF B USINESS U NIVERSITY OF C ALIFORNIA AT B ERKELEY UGBA 103 A VINASH V ERMA S OLUTION TO H OMEWORK 11 1. Both Firm A and Firm B have total assets with a market value of $120 million. For both firms, fixed assets account for 70% of the total assets, and cash available for investment accounts for the remaining 30%. The market value of the fixed assets is assumed to remain unchanged from year to year. Both firms have debt in their capital structure. The promised future value of the debt of Firm A, which is due in exactly a year, is $55 million. The rate of return on Firm A’s debt in both promised and the expected terms is 10%. All of Firm B’s debt is also due in exactly a year. Its promised future value is $168.75 million. The promised rate of interest on Firm B’s debt is 12.5%. Recall that the promised future value of debt equals the sum of the principal and interest. (a): Prepare the balance sheet for the two firms in terms of market value. FIRM A: ASSETS MV [$m] LIABILITIES MV [$m] CASH 36 DEBT=[1/1.1]*Min[$55m, FV(A)] 50 FIXED ASSETS 84 EQUITY=Total -Debt 70 TOTAL ASSETS 120 TOTAL LIABILITIES + Equity 120 FIRM B: ASSETS MV [$m] LIABILITIES MV [$m] CASH 36 DEBT=[1/1.125]*Min[$168.75m, FV(A)] 120 - e FIXED ASSETS 84 EQUITY=Total -Debt e TOTAL ASSETS 120 TOTAL LIABILITIES + Equity 120 Project X has a life of 1 year, and involves an outlay of $36 million. It will generate a cash inflow of $3375 million in Event 1, which occurs with a probability of 0.01, and nothing otherwise. The cost of capital for the project is 35%. Project Y also has a life of one year, and also involves an outlay of $36 million. It will produce a cash inflow of $72 million next year with certainty. The risk free rate is 8%. (b): Indicate whether the following statements are true or false: (i): Project Y has a positive NPV so long as the risk free rate is less than 100%. True: NPV(Y)=-36+72/(1+r f ); r f <1 NPV>0 (ii): Project X has a negative NPV so long as its cost of capital is positive. True:
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This note was uploaded on 04/30/2010 for the course L&S 101 taught by Professor Chow during the Spring '10 term at Berkeley.

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S11 - HASS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT...

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