FI311+Review+problems - Case 3 Finance 311 Due Tuesday,...

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Case 3 Finance 311 Due Tuesday, November 16 th Name (print): 1. A consultant has collected the following information regarding Young Publishing: Total assets $3,000 million Tax rate 40% Operating income (EBIT) $800 million Debt ratio 0% Interest expense $0 million WACC 10% Net income $480 million M/B ratio 1.00× Share price $32.00 EPS = DPS $3.20 The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20 percent debt and 80 percent equity (based on market values) that the cost of equity will increase to 11 percent and that the pre-tax cost of debt will be 10 percent. If the company makes this change, what would be the total market value of the firm? (The answers are in millions.) 1
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2. Dabney Electronics currently has no debt. Its operating income is $20 million and its tax rate is 40 percent. It pays out all of its net income as dividends and has a zero growth rate. The current stock price is $40 per share, and it has 2.5 million shares of stock outstanding. If it moves to a capital structure that has 40 percent debt and 60 percent equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10 percent. What would its stock price be if it changes to the new capital structure? 3. Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon has a capital structure that consists of 20 percent debt and 80 percent equity, based on market values. (Its D/S ratio is 0.25.) The risk-free rate is 6 percent and the market risk premium, r M – r RF , is 5 percent. Currently the company’s cost of equity, which is based on the CAPM, is 12 percent and its tax rate is 40 percent. What would be Simon’s estimated cost of equity if it were to change its capital structure to 50 percent debt and 50 percent equity? 2
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4. Aaron Athletics is trying to determine its optimal capital structure. The company’s capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table: Percent financed Percent financed Debt-to-equity Bond Before-tax With debt (w d ) with equity (w c ) ratio (D/S) rating cost of debt 0.10 0.90 0.10/0.90 = 0.11 AA 7.0% 0.20 0.80 0.20/0.80 = 0.25 A 7.2 0.30 0.70 0.30/0.70 = 0.43 A 8.0 0.40 0.60 0.40/0.60 = 0.67 BB 8.8 0.50 0.50 0.50/0.50 = 1.00 B 9.6 The company’s tax rate, T, is 40 percent. The company uses the CAPM to estimate its cost of common equity, r s . The risk-free rate is 5 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (Its “unlevered beta,” b
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This note was uploaded on 12/14/2010 for the course FIN 422 taught by Professor Sridharsundaram during the Fall '09 term at Grand Valley State University.

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FI311+Review+problems - Case 3 Finance 311 Due Tuesday,...

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