Assignment 4 Solutions

Assignment 4 Solutions - M GCR 341: Finance 1 Summer 2010...

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MGCR 341: Finance 1 Summer 2010 Vadim di Pietro Assignment 4 Solutions 1) Topic: Capital Structure (taxes) The risk free rate is 10%. Assume investors are risk neutral, so that you can discount expected cash flows at the risk free rate. The corporate tax rate is 40% . Ignore bankruptcy costs, as well as any other potential market frictions/imperfections, except corporate taxes. You have identified a factory that you can purchase today for $150. The factory will produce expected earnings before interest and taxes (EBIT) of $40 in perpetuity. (Assume that all after interest and tax earnings are paid out as dividends.)You have 100$ (and no other assets), and you need another $50 to purchase the factory. a) If you issue equity to raise $50, what fraction of the company will you have to sell? If you issue equity and purchase the factory the present value of all equity will be given by the formula for the present value of the after tax cash flow in perpetuity: 40(1-0.40)/0.10 = 240 To raise 50, you have to give up a fraction X of your company such that (X)(240) = 50 X = 0.2083 b) What is your NPV of buying this factory by issuing equity?
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Assignment 4 Solutions - M GCR 341: Finance 1 Summer 2010...

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