FIN 010 Chapter Notes - Chapter 4: Equity Premium Puzzle, Preferred Stock, Capital Structure

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amaranthweasel363

7 Apr 2020

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SBCC

Department

Finance

Course

FIN 010

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Document Summary

A funding business faces the same tradeoff: if it is funding using a mechanism that causes more risk for investors, it would have to give them a greater return than if it uses a less risky mechanism. This relationship is central to deciding the capital costs and optimal mix of funding for a business. Below we can see how these dealings contribute to the financing of a business. First, though, let"s consider the place in the capital structure of the company that investors have in the new shares of abc co as business owners, equity holders are the first to suffer losses should the worst happen. If a company faces financial problems that cause substantial losses, its retained earnings account, maintained for the benefit of equity holders, will be exhausted. The initial losses are largely absorbed by the equity holders during this time of financial distress.

Related Questions

F1 Q11-15

Please show all workings/give explanations

Note: Questions 11 â 20 are based on the same mega problem. For convenience we have included the entire set of information in every question. For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other. This is the assumption we made in most of the videos to focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

Q11. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. What is the value of your company assuming that it will be all-equity financed? (Enter the nearest rounded dollar number without any $ or comma sign.)

Q12. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You decide to start the business and issue 500,000 shares to finance an all-equity firm, the price per share will be (Enter the number with up to two decimals but without any $ or comma sign):

Q13. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You decide to start the business and issue 500,000 shares to finance an all-equity firm. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Assuming that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, if you take this debt and retire shares using the debt, the value of the firm will go:

a) Remain the same.

b) Down.

c) Cannot determine based on the available information.

d) Up.

Q14. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You decide to start the business and issue 500,000 shares to finance an all-equity firm. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you are seriously contemplating taking on the debt and using all of it to retire some shares. If you decide to enter this debt contract with the bank, the value of the firm will become (Enter the nearest rounded dollar number without any $ or comma sign):

Q15. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. Soon thereafter hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you are seriously contemplating taking on the debt and using all of it to retire some shares. If you decide to enter this debt contract with the bank, what will be the price per share of the remaining shares? (Enter the nearest rounded dollar number without any $ or comma sign):

Question 1

In a world with no frictions (taxes, etc.), value is created by how you finance a project.

Your Answer

False. True.

Question 2

(5 points) The return on equity is equal to the return on assets of a project/firm.

Your Answer

Never true.

Always true.

Sometimes true.

Question 3

Suppose the expected returns on equity of two firms, Macrosoft and Microsoft, that operate in the same industry are 10.50% and 12.60%, respectively. What is the return on assets in this business if Macrosoft has no debt? (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

Answer: _____________________

Question 4

Suppose CAPM holds, and the beta of the equity of your company is 2.00. The expected market risk premium (the difference between the expected market return and the risk-free rate) is 4.5% and the risk-free rate is 3.00%. Suppose the debt-to-equity ratio of your company is 20% and the market believes that the beta of your debt is 0.20. What is return on assets of your business? (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

Answer: _____________________

Question 5

You are planning on opening a restaurant chain. You have projected yearly cash flows of $10 million starting next year (t = 1) with a growth rate of 1% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar restaurant businesses equity has an average beta of 1.20 and the average debt-to-value ratio in this industry is 25%. The risk-free rate is 3.25% and the expected market risk premium (the average difference between between the market return and the risk-free rate) is 4.50%. What is the value of the cash flows of your business?

Your Answer Score Explanation

Do not have enough information to calculate.

158730159.

130718954.

Question 6

You have just returned to your job after completing your MBA, generously funded by the CEO. A few days later, your CEO requests you to evaluate the following news release he will issue to analysts. "For years we have thought about our business strategy, without worrying about financing. Times have changed and we need to think about our cost of capital. Since (a) debt is always cheaper than equity; (b) we have decided to use debt to finance our next major projects." What is your assessment of this statement?

Your Answer

The statement is false.

The statement is true.

The statement is partly true/false.

Question 7

Two firms, Alpha, Inc., and Beta, Inc., are in the same business. Alpha, Inc., has debt that is viewed by the market as risk-less with a market value of $500 million. Beta, Inc., has no debt. Both firms are expected to generate cash flows of $100 million per year for the foreseeable future and the market value of the equity of Beta, Inc is $1 billion. Estimate the return on equity of Alpha, Inc. Assume there are no taxes, and the risk-free rate is 5%. (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

Answer: _____________________

Question 8

Mango, Inc. has had debt with market value of $1 million that has paid a 6% coupon and has had an expiration date that is far, far away. The expected annual earnings before interest and taxes for the firm are $2 million and the firm has not grown, nor does it have plans for any growth. The firm however has just raised more equity to retire all its debt. If the required rate of return to equity-holders (after the capital structure change) is now 20%, what is the market value of the firm? Assume there are no taxes. (Enter just the number without the $ sign or a comma; round to the nearest whole dollar.)

Answer: _____________________

Question 9

Suppose all investors are risk-averse and hold diversified portfolios. You are evaluating a new energy company that is going to use wind and will have two divisions: an electricity production unit and a Sales unit. [Transportation of the electricity will be outsourced.] Your CEO and you are arguing about whether projects that emerge in the two units should have the same cost of capital (WACC), or whether the discount rates should be different. If different, what should be the relative magnitudes of the discount rates, that is, which unit Production or Sales should have the higher discount rate. Assume the discount rates of the two units are labeled as P and S, for the production and Sales units, respectively. What do you think?

Your Answer

S>P.

P>S.

Same discount rates for both divisions/units (P=S).

Question 10

NorthSouth Airlines has been granted permission to fly passengers between major U.S. cities. The new company faces competition from four airlines that operate between the major cities. The betas of the equity of the four major competitors (A, B, C, D) are 2.25, 2.50, 2.75, and 3.00; and the debt-to-equity ratios of these four companies (in the same order: A, B, C, D) are 0.21, 0.42, 0.63, 0.83. Although these D/E ratios vary, all airline debt is rated the same. Suppose the yield on airline debt is 7%, the risk-free rate is 3% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 5%. What is the cost of capital (or discount rate) that you should use in valuing NorthSouth Airlines? (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

Answer: _____________________

skycricket77

Intermediate Financial Management 11th Edition

Chapter 15: Capital Structure Decisions Part 1 Mini Case

Assume you have just been hired as a business manager of PizzaPalace, a regional pizze restaurant chain. The company EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms' owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt for the firm at different capital structures:

PERCENT FINANCED WITH DEBT, Wd	rd
0%	-
20	8.0%
30	8.5
40	10.0
50	12.0

If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock. PizzaPalace is in the 40% state-plus-federal corprate tax bracket, its beta is 1.0, the risk free rate is 6%, and the market risk premium is 6%.

Please answer All Parts:

Part A: Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the WACC and free cash flows.

Part B: 1) What is business risk? What factors influence a firm's business risk? 2) What is operating leverage, and how does it affect a firm's business risk? Show the operating breakeven point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.

Part C: Now, to develop an example that can be presented to PizzaPalace's management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $10,000 of 12% debt. Both firms have $20,000 in assets, a 40% tax rate, and an expected EBIT of $3,000. 1) Construct partial income statements, which start with EBIT, for the two firms. 2) Now calculate ROE for both firms. 3) What does this example illustrate about the impact of financial leverage on ROE?

Part D: Explain the difference between financial risk and business risk.

Part E: What happens to ROE for Firms U and L if EBIT falls to $2,000? What does this imply about the impact of leverage on risk and return?

Part F: What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.

Part G: What does the empirical evidence say about capital structure theory? What are the implications for managers?

Part H: With the preceding points in mind, now consider the optimal capital structure for PizzaPalace. 1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. 2) Now calculate the corporate value for each capital structure.

Part I: Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting value of the debt that will be issued, the resulting market value of equity, the price per share, the number of shares repurchased, and the remaining shares. Considering only the capital structures under analysis, what is PizzaPalace's optimal capital structure?

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FIN 010 Chapter Notes - Chapter 4: Equity Premium Puzzle, Preferred Stock, Capital Structure

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