STC7&amp;8PS

# STC7&amp;8PS - Solutions to Chapters 7 8 Problem Sets...

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Solutions to Chapters 7 & 8 Problem Sets

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7-11. ABC Incorporated shares are currently trading for \$32 per share. The firm has 1.13 billion shares outstanding. In addition, the market value of the firm’s outstanding debt is \$2 billion. The 10-year Treasury bond rate is 6.25%. ABC has an outstanding credit record and has earned an AAA rating from the major credit rating agencies. The current interest rate on AAA corporate bonds is 6.45%. The historical risk premium for stocks over the risk-free rate of return is 5.5 percentage points. The firm’s beta is estimated to be 1.1 and its marginal tax rate, including federal, state, and local taxes is 40%. What is the cost of equity (COE)? What is the after-tax cost of debt? What is the weighted average cost of capital (WACC)? COE = .0625 + 1.1 (.055) = .123 i(after-tax cost of debt) = .0645 x (1-.4) = .039 WACC = {(32x1.13)/38.16} x .1230 + {2.0/38.16} x .039 = .1166 + .002 = . 119
7-12. HiFlyer Corporation does not currently have any debt. Its tax rate is .4 and its unlevered beta is estimated by examining comparable companies to be 2.0. The 10-year Treasury bond rate is 6.25% and the historical risk premium over the risk free rate is 5.5%. Next year, HiFlyer expects to borrow up to 75% of its equity value to fund future growth. Calculate the firm’s current cost of equity. Estimate the firm’s cost of equity after it increases its leverage to 75% of equity? COE = .0625 + 2.0 (5.5) = .1725 COE (with leverage) = .0625 + B l (5.5), where B l = B u (1+(D/E)(1-t)) =2.0(1+(.75)(.6)) = 2.9 = .0625 + 2.9(.055) = .222

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7-13. Abbreviated financial statements are given for Fletcher Corporation in the following table: 2001 2002 Revenues \$600.0 \$690.0 Operating expenses 520.0 600.0 Depreciation 16.0 18.0 Earnings before interest and taxes 64.0 72.0 Less Interest Expense 5.0 5.0 Less: Taxes 23.6 26.8 Equals: Net income 35.4 40.2 Addendum: Yearend working capital 150 200 Principal repayment 25.0 25.0 Capital expenditures 20 10 Yearend working capital in 2000 was \$160 million and the firm’s marginal tax rate is 40% in both 2001 and 2002. Estimate the following for 2001 and 2002: a.Free cash flow to equity. b.Free cash flow to the firm. Answers: a.\$16.4 million in 2001 and \$(26.8) million in 2002 b.\$44.4 million in 2001 and \$1.2 million in 2002 FCFE2001= NI + Dep – Capex – Chg WC – Principal Repayments = 35.4 + 16 – 20 – (150-160) – 25 = 16.4 FCFE2002 = 40.2 + 18 – 10 – (200 –150) –25 = -26.8 FCFF2001 = EBIT (1-t) + Dep –Capex – Chg. WC = 64 (1-.4) + 16 – 20 – (150-160) = 44.4 FCFF2002 = 72 (1-.4) + 18 – 10 – (200-150) = 1.2
7-14. No Growth Incorporated had operating income before interest and taxes in 2002 of \$220 million. The firm was expected to generate this level of operating income indefinitely. The firm had depreciation expense of \$10 million that same year. Capital spending totaled \$20 million during 2002. At the end of 2001 and 2002, working capital totaled \$70 and \$80 million, respectively. The

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STC7&amp;8PS - Solutions to Chapters 7 8 Problem Sets...

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