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Unformatted text preview: costs to the debt issue include potential bankruptcy and financial distress costs. The indirect costs of an equity issue include shirking and perquisites. The interest payments each year will be: Interest payment = .08($70,000) = $5,600 This is exactly equal to the EBIT, so no cash is available for shareholders. Under this scenario, the value of equity will be zero since shareholders will never receive a payment. Since the market value of the company’s debt is $70,000, and there is no probability of default, the total value of the company is the market value of debt. This implies the debt to value ratio is 1 (one). b. At a 3 percent growth rate, the earnings next year will be: Earnings next year = $5,600(1.03) = $5,768 So, the cash available for shareholders is: Payment to shareholders = $5,768 – 5,600 = $168 Since there is no risk, the required return for shareholders is the same as the required return on the company’s debt. The payments to stockholders will increase at the growth rate of three percent (a growing perpetuity), so the value of these payments today is: Value of equity = $168 / (.08 – .03) = $3,360.00 And the debt to value ratio now is: Debt/Value ratio = $70,000 / ($70,000 + 3,360) = 0.954 c. 3. a. 370 c. At a 7 percent growth rate, the earnings next year will be: Earnings next year = $5,600(1.07) = $5,992.00 So, the cash available for shareholders is: Payment to shareholders = $5,992 – 5,600 = $392 Since there is no risk, the required return for shareholders is the same as the required return on the company’s debt. The payments to stockholders will increase at the growth rate of seven percent (a growing perpetuity), so the value of these payments today is: Value of equity = $392 / (.08 – .07) = $39,200 And the debt to value ratio now is: Debt/Value ratio = $70,000 / ($70,000 + 39,200) = 0.641 4. According to M&M Proposition I with taxes, the value of the levered firm is: VL = VU + tCB VL = $14,500,000 + .35($5,000,000) VL = $16,250,000 We can also calculate the market value of the firm by adding the market value of the debt and equity. Using this procedure, the total market value of the firm is: V=B+S V = $5,000,000 + 300,000($35) V = $15,500,000 With no nonmarketed claims, such as bankruptcy costs, we would expect the two values to be the same. The difference is the value of the nonmarketed claims, which are: VT = VM + VN $15,500,000 = $16,250,000 – VN VN = $750,000 5. The president may be correct, but he may also be incorrect. It is true the interest tax shield is valuable, and adding debt can possibly increase the value of the company. However, if the company’s debt is increased beyond some level, the value of the interest tax shield becomes less than the additional costs from financial distress. 371 Intermediate 6. a. The total value of a firm’s equity is the discounted expected cash flow to the firm’s stockholders. If the expansion continues, each firm will generate earnings before interest and taxes of $2.4 million. If there is a recession, each firm will generate earnings before interest and taxes of only $900,000. Since Steinberg owes its bondholders $800,000 at the end of the year, its stockholders will receive $1.6 million (= $2,400,000 – 800,000) if the expansion continues. If there is a recession, its stockholders will only receive $100,000 (= $900,000 – 800,000). So, assuming a discount rate of 15 percent, the market value of Steinberg’s equity is: SSteinberg = [.80($1,600,000) + .20($100,000)] / 1.15 = $1,130,435 Steinberg’s bondholders will receive $800,000 whether there is a recession or a continuation of the expansion. So, the market value of Steinberg’s debt is: BSteinberg = [.80($800,000) + .20($800,000)] / 1.15 = $695,652 Since Dietrich owes its bondholders $1.1 million at the end of the year, its stockholders will receive $1.3 million (= $2.4 million – 1.1 million) if the expansion continues. If there is a recession, its stockholders will receive nothing since the firm’s bondholders have a more senior claim on all $800,000 of the firm’s earnings. So, the market value of Dietrich’s equity is: SDietrich = [.80($1,300,000) + .20($0)] / 1.15 = $904,348 Dietrich’s bondholders will receive $1.1 million if the expansion continues and $900,000 if there is a recession. So, the market value of Dietrich’s debt is: BDietrich = [.80($1,100,000) + .20($900,000)] / 1.15 = $921,739 b. The value of company is the sum of the value of the firm’s debt and equity. So, the value of Steinberg is: VSteinberg = B + S VSteinberg = $1,130,435 + $695,652 VSteinberg = $1,826,087 And value of Dietrich is: VDietrich = B + S VDietrich = $904,348 + 921,739 VDietrich = $1,826,087 You should disagree with the CEO’s statement. The risk of bankruptcy per se does not affect a firm’s value. It is the actual costs of bankruptcy that decrease the value of a firm. Note that this problem assumes that there are no bankruptcy costs. 372 7. a. The expected value of each project is the sum of the probability of each state of the economy times the va...
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 Spring '10
 eshmalwi
 Finance, Corporate Finance

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