CH19

Fundamentals of Corporate Finance + Standard & Poor's Educational Version of Market Insight

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CHAPTER 19 Financing and Valuation Answers to Practice Questions 1. If the bank debt is treated as permanent financing, the capital structure proportions are: Bank debt (r D = 10 percent) $280 9.4% Long-term debt (r D = 9 percent) 1800 60.4 Equity (r E = 18 percent, 90 x 10 million shares) 900 30.2 $2980 100.0% WACC* = [0.10 × (1 - 0.35) × 0.094] + [0.09 × (1 - 0.35) × 0.604] + [0.18 × 0.302] = 0.096 = 9.6% 2. Forecast after-tax incremental cash flows as explained in Section 6.1. Interest is not included; the forecasts assume an all-equity financed firm. 3. Calculate APV by subtracting $4 million from base-case NPV. 4. We make three adjustments to the balance sheet: Ignore deferred taxes; this is an accounting entry and represents neither a liability nor a source of funds ‘Net out’ accounts payable against current assets Use the market value of equity (7.46 million x $46) Now the right-hand side of the balance sheet (in thousands) looks like: Short-term debt $75,600 Long-term debt 208,600 Share holder equity 343,160 Total $627,360 The after-tax weighted-average cost of capital formula, with one element for each source of funding, is: WACC = [r D-ST × (1 – T c ) × (D-ST/V)]+[r D-LT × (1 – T c ) × (D-LT/V)]+[r E × (E/V)] WACC = [0.06 × (1 - 0.35) × (75,600/627,360)] + [0.08 × (1 - 0.35) × (208,600/627,360)] + [0.15 × (343,160/627,360)] 169
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= 0.004700 + 0.017290 + 0.082049 = 0.1040 = 10.40% 5. Assume that short-term debt is temporary. From Practice Question 4: Long-term debt $208,600 Share holder equity 343,160 Total $551,760 Therefore: (D/V) = ($208,600/$551,760) = 0.378 (E/V) = ($343,160/$551,760) = 0.622 Step 1: r = r D (D/V) + r E (E/V) = (0.08 × 0.378) + (0.15 × 0.622) = 0.1235 Step 2: r E = r + (r – r D ) (D/E) = 0.1235 + (0.1235 - .08) × (0.4) = 0.1409 Step 3: WACC = [r D × (1 – T C ) × (D/V)] + [r E × (E/V)] = (0.08 × 0.65 × 0.286) + (0.1409 × 0.714) = 0.1155 = 11.55% 6. Pre-tax operating income $100.5 Short-term interest 4.5 Long-term interest 16.7 Earnings before tax $79.3 Tax 27.8 Net income $51.5 Value of equity = $51.5/0.15 = $343.3 Value of firm = $343.3 + $75.6 + $208.6 = $627.5 7. The problem here is that issue costs are a one-time expenditure, while adjusting the WACC implies a correction every year. The only way to account for issue costs in project evaluation is to use the APV formulation and adjust directly by subtracting the issue costs from the base case NPV. 8. a. Base case NPV = -1,000 + (600/1.12) + (700/1.12 2 ) = $93.75 or $93,750 Year Debt Outstanding at Start Of Year Interest Interest Tax Shield PV (Tax Shield) 1 300 24 7.20 6.67 170
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2 150 12 3.60 3.09 APV = 93.75 + 6.67 + 3.09 = 103.5 or $103,500 9. [$100,000 × (1 - 0.35)] + [$100,000 × (1 - 0.35) × (Annuity Factor 5/9 (1 – 0.35)% )] = $65,000 + $274,925 = $339,925 10. a. Base-case NPV = -$1,000,000 + ($85,000/0.10) = -$150,000 PV(tax shields) = 0.35 × $400,000 = $140,000 APV = -$150,000 + $140,000 = -$10,000 b. PV(tax shields, approximate) = (0.35
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CH19 - CHAPTER 19 Financing and Valuation Answers to...

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