Corporate Finance - Chapter 16 and 17

award:10.00points

Money, Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest andtaxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansionin the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 40 percentlower. Money is considering a $99,000 debt issue with an interest rate of 8 percent. The proceeds will beused to repurchase shares of stock. There are currently 5,000 shares outstanding. Ignore taxes for thisproblem. a-1.Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is

issued. (Do not round intermediate calculations and round your final answers to 2 decimalplaces. (e.g., 32.16))

EPS Recession $ 2.52 1% Normal $ 4.20 1% Expansion $ 5.25 1%

a-2.Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do

not round intermediate calculations. Negative amounts should be indicated by a minus sign.)

Percentage changes in EPS Recession -40 1% % Expansion 25 1% %

b-1.Assume that the company goes through with recapitalization. Calculate earnings per share (EPS)

under each of the three economic scenarios. (Do not round intermediate calculations and roundyour final answers to 2 decimal places. (e.g., 32.16))


b-2.Given the recapitalization, calculate the percentage changes in EPS when the economy expands or

enters a recession. (Negative amounts should be indicated by a minus sign. Do not roundintermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Percentage changes in EPS

Recession -64.22 1% % Expansion 40.14 1% %

Explanation:

a.A table outlining the income statement for the three possible states of the economy is shown below. TheEPS is the net income divided by the 5,000 shares outstanding. The last row shows the percentagechange in EPS the company will experience in a recession or an expansion economy. Recession Normal Expansion EBIT $ 12,600 $ 21,000 $ 26,250 Interest 0 0 0 NI $ 12,600 $ 21,000 $ 26,250 EPS $ 2.52 $ 4.20 $ 5.25 %EPS 40 + 25

b.If the company undergoes the proposed recapitalization, it will repurchase:

Assignment Print View http://ezto.mhecloud.mcgraw-hill.com/hm_finance.tpx

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Share price = Equity / Shares outstandingShare price = $275,000 / 5,000Share price = $55 Shares repurchased = Debt issued / Share priceShares repurchased = $99,000 / $55Shares repurchased = 1,800 The interest payment each year under all three scenarios will be: Interest payment = $99,000(.08) = $7,920 The last row shows the percentage change in EPS the company will experience in a recession or anexpansion economy under the proposed recapitalization. Recession Normal Expansion EBIT $ 12,600 $ 21,000 $ 26,250 Interest 7,920 7,920 7,920 NI $ 4,680 $ 13,080 $ 18,330 EPS $ 1.46 $ 4.09 $ 5.73 %EPS 64.22 + 40.14

View Hint #1

Worksheet Difficulty: Basic


3 of 21 3/19/2014 3:53 PM

award:10.00points

Money, Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest andtaxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansionin the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 40 percentlower. Money is considering a $99,000 debt issue with an interest rate of 8 percent. The proceeds will beused to repurchase shares of stock. There are currently 5,000 shares outstanding. Money has a tax rateof 35 percent. a-1.Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is

issued. (Do not round intermediate calculations and round your final answers to 2 decimalplaces. (e.g., 32.16))


a-2.Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do

not round intermediate calculations. Negative amounts should be indicated by a minus sign.)

Percentage changes in EPS Recession -40 1% % Expansion 25 1% %

b-1.Assume that the company goes through with recapitalization. Calculate earnings per share (EPS)

under each of the three economic scenarios. (Do not round intermediate calculations and roundyour final answers to 2 decimal places. (e.g., 32.16))

EPS Recession $ .95 0.01 Normal $ 2.66 1% Expansion $ 3.72 1%

b-2.Given the recapitalization, calculate the percentage changes in EPS when the economy expands or

enters a recession. (Negative amounts should be indicated by a minus sign. Do not roundintermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Percentage changes in EPS

Recession -64.22 1% % Expansion 40.14 1% %

Explanation:

a.A table outlining the income statement with taxes for the three possible states of the economy is shownbelow. The share price is $55, and there are 5,000 shares outstanding. The last row shows thepercentage change in EPS the company will experience in a recession or an expansion economy. Recession Normal Expansion EBIT $ 12,600 $ 21,000 $ 26,250 Interest 0 0 0 Taxes 4,410 7,350 9,188 NI $ 8,190 $ 13,650 $ 17,063 EPS $ 1.64 $ 2.73 $ 3.41 %EPS 40 + 25

b.


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If the company undergoes the proposed recapitalization, it will repurchase: Share price = Equity / Shares outstandingShare price = $275,000 / 5,000Share price = $55 Shares repurchased = Debt issued / Share priceShares repurchased = $99,000 / $55Shares repurchased = $1,800 The interest payment each year under all three scenarios will be: Interest payment = $99,000(.08) = $7,920 A table outlining the income statement with taxes for the three possible states of the economy andassuming the company undertakes the proposed capitalization is shown below. The last row shows the percentage change in EPS the company will experience in a recession or anexpansion economy under the proposed recapitalization. Recession Normal Expansion EBIT $ 12,600 $ 21,000 $ 26,250 Interest 7,920 7,920 7,920 Taxes 1,638 4,578 6,416 NI $ 3,042 $ 8,502 $ 11,915 EPS $ .95 $ 2.66 $ 3.72 %EPS 64.22 +40.14 Notice that the percentage change in EPS is the same both with and without taxes.



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award:10.00points

Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a leveredplan (Plan II). Under Plan I, Rolston would have 265,000 shares of stock outstanding. Under Plan II,there would be 185,000 shares of stock outstanding and $2.8 million in debt outstanding. The interestrate on the debt is 10 percent and there are no taxes. a. If EBIT is $750,000, what is the EPS for each plan? (Do not round intermediate calculations and

round your final answers to 2 decimal places. (e.g., 32.16))

EPS Plan I $ 2.83 1% Plan II $ 2.54 1%

b. If EBIT is $1,500,000, what is the EPS for each plan? (Do not round intermediate calculations

and round your final answers to 2 decimal places. (e.g., 32.16))

EPS Plan I $ 5.66 1% Plan II $ 6.59 1%

c. What is the break-even EBIT? (Enter your answer in dollars, not millions of dollars, i.e.

1,234,567. Do not round intermediate calculations.)

Break-even EBIT $ 927,500 0.1%

Explanation:

a.Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPSunder this capitalization will be: EPS = $750,000 / 265,000 sharesEPS = $2.83 Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest paymentis the amount of debt times the interest rate, so: NI = $750,000 .10($2,800,000)NI = $470,000 And the EPS will be: EPS = $470,000 / 185,000 sharesEPS = $2.54 Plan I has the higher EPS when EBIT is $750,000. b.Under Plan I, the net income is $1,500,000 and the EPS is: EPS = $1,500,000 / 265,000 sharesEPS = $5.66 Under Plan II, the net income is: NI = $1,500,000 .10($2,800,000)NI = $1,220,000 And the EPS is: EPS = $1,220,000 / 185,000 shares


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award:10.00points

EPS = $6.59 Plan II has the higher EPS when EBIT is $1,500,000. c.To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS equalto each other and solve for EBIT. The breakeven EBIT is: EBIT / 265,000 = [EBIT .10($2,800,000)] / 185,000EBIT = $927,500

View Hint #1


Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a leveredplan (Plan II). Under Plan I, Rolston would have 265,000 shares of stock outstanding. Under Plan II,there would be 185,000 shares of stock outstanding and $2.8 million in debt outstanding. The interestrate on the debt is 10 percent and there are no taxes. Use MM Proposition I to find the price per share. (Do not round intermediate calculations.) Share price $ 35.00 1% per share What is the value of the firm under each of the two proposed plans? (Do not round intermediatecalculations. Enter your answers in dollars, not millions of dollars, i.e. 1,234,567.) Value of the firm All equity plan $ 9,275,000 0.01% Levered plan $ 9,275,000 0.01%

Explanation:

We can find the price per share by dividing the amount of debt used to repurchase shares by the numberof shares repurchased. Doing so, we find the share price is: Share price = $2,800,000 / (265,000 185,000)Share price = $35.00 per share The value of the company under the all-equity plan is: V= $35(265,000 shares) = $9,275,000 And the value of the company under the levered plan is: V = $35(185,000 shares) + $2,800,000 debt = $9,275,000

View Hint #1



7 of 21 3/19/2014 3:53 PM

award:10.00points

Kolby Corp. is comparing two different capital structures. Plan I would result in 900 shares of stock and$65,700 in debt. Plan II would result in 1,900 shares of stock and $29,200 in debt. The interest rate onthe debt is 10 percent. a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $8,500.

The all-equity plan would result in 2,700 shares of stock outstanding. What is the EPS for each ofthese plans? (Do not round intermediate calculations and round your final answers to 2decimal places. (e.g., 32.16))

EPS Plan I $ 2.14 1% Plan II $ 2.94 1% All equity $ 3.15 1%

b. In part (a) what are the break-even levels of EBIT for each plan as compared to that for an all-equity

plan? (Do not round intermediate calculations and round your final answers to 2 decimalplaces. (e.g., 32.16))

EBIT Plan I and all-equity $ 9,855 0.1% Plan II and all-equity $ 9,855 0.1%

c. Ignoring taxes, at what level of EBIT will EPS be identical for Plans I and II? (Do not round

intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

EBIT $ 9,855 0.1% d-1.Assuming that the corporate tax rate is 40 percent, what is the EPS of the firm for each of these

plans? (Do not round intermediate calculations and round your final answers to 2 decimalplaces. (e.g., 32.16))

EPS Plan I $ 1.29 1% Plan II $ 1.76 1% All equity $ 1.89 1%

d-2.Assuming that the corporate tax rate is 40 percent, what are the break-even levels of EBIT for each

plan as compared to that for an all-equity plan? (Do not round intermediate calculations andround your final answers to 2 decimal places. (e.g., 32.16))

EBIT Plan I and all-equity $ 9,855 0.1% Plan II and all-equity $ 9,855 0.1%

d-3.Assuming that the corporate tax rate is 40 percent, when will EPS be identical for Plans I and II? (Do

not round intermediate calculations and round your final answers to 2 decimal places. (e.g.,32.16))

EBIT $ 9,855 0.1%

Explanation:

a.The income statement for each capitalization plan is: I II All-equity EBIT $ 8,500 $ 8,500 $ 8,500 Interest 6,570 2,920 0


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NI $ 1,930 $ 5,580 $ 8,500 EPS $ 2.14 $ 2.94 $ 3.15 The all-equity plan has the highest EPS; Plan I has the lowest EPS. b.The breakeven level of EBIT occurs when the capitalization plans result in the same EPS. The EPS iscalculated as: EPS = (EBIT R

BB) / Shares outstanding

This equation calculates the interest payment (R

BB) and subtracts it from the EBIT, which results in the

net income. Dividing by the shares outstanding gives us the EPS. For the all-equity capital structure, theinterest paid is zero. To find the breakeven EBIT for two different capital structures, we simply set theequations equal to each other and solve for EBIT. The breakeven EBIT between the all-equity capitalstructure and Plan I is: EBIT / 2,700 = [EBIT .10($65,700)] / 900EBIT = $9,855 And the breakeven EBIT between the all-equity capital structure and Plan II is: EBIT / 2,700 = [EBIT .10($29,200)] / 1,900EBIT = $9,855 The break-even levels of EBIT are the same because of M&M Proposition I. c.Setting the equations for EPS from Plan I and Plan II equal to each other and solving for EBIT, we get: [EBIT .10($65,700)] / 900 = [EBIT .10($29,200)] / 1,900EBIT = $9,855 This break-even level of EBIT is the same as in part b again because of M&M Proposition I. d.The income statement for each capitalization plan with corporate income taxes is: I II All-equity EBIT $ 8,500 $ 8,500 $ 8,500 Interest 6,570 2,920 0 Taxes 772 2,232 3,400 NI $ 1,158 $ 3,348 $ 5,100 EPS $ 1.29 $ 1.76 $ 1.89 The all-equity plan still has the highest EPS; Plan I still has the lowest EPS. We can calculate the EPS as: EPS = [(EBIT R

BD)(1 t

C)] / Shares outstanding

This is similar to the equation we used before, except that now we need to account for taxes. Again, theinterest expense term is zero in the all-equity capital structure. So, the breakeven EBIT between theall-equity plan and Plan I is: EBIT(1 .40) / 2,700 = [EBIT .10($65,700)](1 .40) / 900EBIT = $9,855


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The breakeven EBIT between the all-equity plan and Plan II is: EBIT(1 .40) / 2,700 = [EBIT .10($29,200)](1 .40) / 1,900EBIT = $9,855 And the breakeven between Plan I and Plan II is: [EBIT .10($65,700)](1 .40) / 900 = [EBIT .10($29,200)](1 .40) / 1,900EBIT = $9,855 The break-even levels of EBIT do not change because the addition of taxes reduces the income of allthree plans by the same percentage; therefore, they do not change relative to one another.



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award:10.00points

Kolby Corp. is comparing two different capital structures. Plan I would result in 900 shares of stock and$65,700 in debt. Plan II would result in 1,900 shares of stock and $29,200 in debt. The interest rate onthe debt is 10 percent. Assume that EBIT will be $8,500. An all-equity plan would result in 2,700 sharesof stock outstanding. Ignore taxes. What is the price per share of equity under Plan I? Plan II? (Do not round intermediate calculationsand round your final answers to 2 decimal places. (e.g., 32.16)) Price per share of equity Plan I $ 36.50 1% per share Plan II $ 36.50 1% per share

Explanation:

To find the value per share of the stock under each capitalization plan, we can calculate the price as thevalue of shares repurchased divided by the number of shares repurchased. The dollar value of theshares repurchased is the increase in the value of the debt used to repurchase shares, or: Dollar value of repurchase = $65,700 29,200 = $36,500 The number of shares repurchased is the decrease in shares outstanding, or: Number of shares repurchased = 1,900 900 = 1,000 So, under Plan I, the value per share is: P = $36,500 / 1,000 sharesP = $36.50 per share And under Plan II, the number of shares repurchased from the all equity plan by the $29,200 in debt are: Shares repurchased = 2,700 1,900 = 800 So the share price is: P = $29,200 / 800 sharesP = $36.50 per share This shows that when there are no corporate taxes, the stockholder does not care about the capitalstructure decision of the firm. This is M&M Proposition I without taxes.



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award:10.00points

Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capitalstructure to one that is 35 percent debt. Currently there are 6,000 shares outstanding and the price pershare is $58. EBIT is expected to remain at $33,000 per year forever. The interest rate on new debt is 8percent, and there are no taxes. a. Ms. Brown, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the

current capital structure, assuming the firm has a dividend payout rate of 100 percent? (Do not roundintermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Cash flow $ 550.00 1%

b. What will Ms. Browns cash flow be under the proposed capital structure of the firm? Assume that she

keeps all 100 of her shares. (Do not round intermediate calculations and round your finalanswer to 2 decimal places. (e.g., 32.16))

Cash flow $ 596.31 1%

c. Assume that Ms. Brown unlevers her shares and re-creates the original capital structure. What is her

cash flow now? (Do not round intermediate calculations and round your final answer to 2decimal places. (e.g., 32.16))

Total Cash flow $ 550.00 1%

Explanation:

a.The earnings per share are: EPS = $33,000 / 6,000 sharesEPS = $5.50 So, the cash flow for the investor is: Cash flow = $5.50(100 shares)Cash flow = $550 b.To determine the cash flow to the shareholder, we need to determine the EPS of the firm under theproposed capital structure. The market value of the firm is: V = $58(6,000)V = $348,000 Under the proposed capital structure, the firm will raise new debt in the amount of: B = .35($348,000)B = $121,800 This means the number of shares repurchased will be: Shares repurchased = $121,800 / $58Shares repurchased = 2,100 Under the new capital structure, the company will have to make an interest payment on the new debt.The net income with the interest payment will be: NI = $33,000 .08($121,800)NI = $23,256 This means the EPS under the new capital structure will be:


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award:10.00points

EPS = $23,256 / (6,000 2,100) sharesEPS = $5.96 Since all earnings are paid as dividends, the shareholder will receive: Shareholder cash flow = $5.96(100 shares)Shareholder cash flow = $596.31 c.To replicate the proposed capital structure, the shareholder should sell 35 percent of her shares, or 35shares, and lend the proceeds at 8 percent. The shareholder will have an interest cash flow of: Interest cash flow = 35($58)(.08)Interest cash flow = $162.40 The shareholder will receive dividend payments on the remaining 65 shares, so the dividends receivedwill be: Dividends received = $5.96(65 shares)Dividends received = $387.60 The total cash flow for the shareholder under these assumptions will be: Total cash flow = $162.40 + 387.60Total cash flow = $550 This is the same cash flow we calculated in part a.

View Hint #1


Nina Corp. uses no debt. The weighted average cost of capital is 9 percent. If the current market value ofthe equity is $37 million and there are no taxes, what is EBIT? (Do not round intermediatecalculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.) EBIT $ 3,330,000 0.01%

Explanation:

With no taxes, the value of an unlevered firm is the interest rate divided by the unlevered cost of equity,so: V = EBIT / WACC$37,000,000 = EBIT / .09EBIT = .09($37,000,000)EBIT = $3,330,000

View Hint #1



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award:10.00points

Nina Corp. uses no debt. The weighted average cost of capital is 9 percent. The current market value ofthe equity is $37 million and the corporate tax rate is 35 percent. What is the EBIT? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do notround intermediate calculations. Round your EBIT answer to 2 decimal places.) EBIT $ 5,123,076.92 0.01% What is the WACC? WACC 9 %

Explanation:

If there are corporate taxes, the value of an unlevered firm is: V

U = EBIT(1 t

C) / R

U Using this relationship, we can find EBIT as: $37,000,000 = EBIT(1 .35) / .09EBIT = $5,123,076.92 The WACC remains at 9 percent. Due to taxes, EBIT for an all-equity firm would have to be higher for thefirm to still be worth $37 million.

View Hint #1



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award:10.00points

Bruce & Co. expects its EBIT to be $185,000 every year forever. The firm can borrow at 9 percent. Brucecurrently has no debt, and its cost of equity is 16 percent. If the tax rate is 35 percent, what is the value of the firm? (Do not round intermediate calculations andround your answer to 2 decimal places. (e.g., 32.16)) Value of the firm $ 751,562.50 0.1% What will the value be if Bruce borrows $135,000 and uses the proceeds to repurchase shares? (Do notround intermediate calculations and round your answer to 2 decimal places. (e.g., 32.16)) Value of the firm $ 798,812.50 0.1%

Explanation:

The value of the unlevered firm is: V = EBIT(1 t

C) / R

0V = $185,000(1 .35) / .16V = $751,562.50 The value of the levered firm is: V = V

U + t

CB

V = $751,562.50 + .35($135,000)V = $798,812.50



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award:10.00points

Tool Manufacturing has an expected EBIT of $57,000 in perpetuity and a tax rate of 35 percent. The firmhas $90,000 in outstanding debt at an interest rate of 8 percent, and its unlevered cost of capital is 15percent. What is the value of the firm according to MM Proposition I with taxes? (Do not round intermediatecalculations.) Value of the firm $ 278,500 0.1%

Explanation:

To find the value of the levered firm, we first need to find the value of an unlevered firm. So, the value ofthe unlevered firm is: V

U = EBIT(1 t

C) / R

0V

U = ($57,000)(1 .35) / .15

VU

= $247,000

Now we can find the value of the levered firm as: V

L= V

U + t

CB

VL = $247,000 + .35($90,000)

VL = $278,500

Applying M&M Proposition I with taxes, the firm has increased its value by issuing debt. As long as M&MProposition I holds, that is, there are no bankruptcy costs and so forth, then the company shouldcontinue to increase its debt / equity ratio to maximize the value of the firm.

View Hint #1

Worksheet Difficulty: Intermediate


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award:10.00points

Janetta Corp. has an EBIT rate of $975,000 per year that is expected to continue in perpetuity. Theunlevered cost of equity for the company is 14 percent, and the corporate tax rate is 35 percent. Thecompany also has a perpetual bond issue outstanding with a market value of $1.9 million. What is the value of the company? (Enter your answer in dollars, not millions of dollars, i.e.1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places.(e.g., 32.16)) Value of the company $ 5,191,785.71 0.01%

Explanation:

Using M&M Proposition I with taxes, the value of a levered firm is: V

L = [EBIT(1 t

C) / R

0] + t

CB

VL = [$975,000(1 .35) / .14] + .35($1,900,000)

VL = $5,191,785.71



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award:10.00points

Tom Scott is the owner, president, and primary salesperson for Scott Manufacturing. Because of this, thecompany's profits are driven by the amount of work Tom does. If he works 40 hours each week, thecompany's EBIT will be $550,000 per year; if he works a 50-hour week, the company's EBIT will be$625,000 per year. The company is currently worth $3.2 million. The company needs a cash infusion of$1.3 million, and it can issue equity or issue debt with an interest rate of 8 percent. Assume there are nocorporate taxes. a. What are the cash flows to Tom under each scenario? (Enter your answers in whole dollars, not

millions of dollars. Do not round intermediate calculations and round your answers to thenearest whole dollar amount. (e.g., 32))

Scenario-1 Debt issue:

Cash flows 40-hour week $ 446,000 0.1% 50-hour week $ 521,000 0.1%

Scenario-2 Equity issue:

Cash flows 40-hour week $ 391,111 0.1% 50-hour week $ 444,444 0.1%

b. Under which form of financing is Tom likely to work harder?

Debt issueEquity issue

Explanation:

a.Debt issue: The company needs a cash infusion of $1.3 million. If the company issues debt, the annual interestpayments will be: Interest = $1,300,000(.08) = $104,000 The cash flow to the owner will be the EBIT minus the interest payments, or: 40-hour week cash flow = $550,000 104,000 = $446,000 50-hour week cash flow = $625,000 104,000 = $521,000 Equity issue: If the company issues equity, the company value will increase by the amount of the issue. So, the currentowner's equity interest in the company will decrease to: Tom's ownership percentage = $3,200,000 / ($3,200,000 + 1,300,000) = .71 So, Tom's cash flow under an equity issue will be 71 percent of EBIT, or: 40-hour week cash flow = .71($550,000) = $391,111 50-hour week cash flow = .71($625,000) = $444,444 b.Tom will work harder under the debt issue since his cash flows will be higher. Tom will gain more under


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this form of financing since the payments to bondholders are fixed. Under an equity issue, new investorsshare proportionally in his hard work, which will reduce his propensity for this additional work.



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award:10.00points

Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered.Both companies will remain in business for one more year. The companies' economists agree that theprobability of the continuation of the current expansion is 80 percent for the next year, and the probabilityof a recession is 20 percent. If the expansion continues, each firm will generate earnings before interestand taxes (EBIT) of $2.7 million. If a recession occurs, each firm will generate earnings before interestand taxes (EBIT) of $1.1 million. Steinberg's debt obligation requires the firm to pay $900,000 at the endof the year. Dietrich's debt obligation requires the firm to pay $1.2 million at the end of the year. Neitherfirm pays taxes. Assume a discount rate of 13 percent. a-1.What is the value today of Steinberg's debt and equity? (Enter your answers in dollars, not

millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round youranswers to the nearest whole dollar amount. (e.g., 32))

Steinberg's Equity value $ 1,309,735 0.01% Debt value $ 796,460 0.1%

a-2.What is the value today of Dietrich's debt and equity? (Enter your answers in dollars, not millionsof dollars, i.e. 1,234,567. Do not round intermediate calculations and round your answers tothe nearest whole dollar amount. (e.g., 32))

Dietrich's Equity value $ 1,061,947 0.01% Debt value $ 1,044,248 0.01%

b. Steinbergs CEO recently stated that Steinbergs value should be higher than Dietrichs because thefirm has less debt and therefore less bankruptcy risk. Do you agree or disagree with this statement?

AgreeDisagree

Explanation:

a.The total value of a firm's equity is the discounted expected cash flow to the firm's stockholders. If theexpansion continues, each firm will generate earnings before interest and taxes of $2,700,000. If there isa recession, each firm will generate earnings before interest and taxes of only $1,100,000. SinceSteinberg owes its bondholders $900,000 at the end of the year, its stockholders will receive $1,800,000(= $2,700,000 900,000) if the expansion continues. If there is a recession, its stockholders will onlyreceive $200,000 (= $1,100,000 900,000). So, assuming a discount rate of 13 percent, the marketvalue of Steinberg's equity is: S

Steinberg = [.80($1,800,000) + .20($200,000)] / 1.13 = $1,309,735

Steinberg's bondholders will receive $900,000 whether there is a recession or a continuation of theexpansion. So, the market value of Steinberg's debt is: B

Steinberg = [.80($900,000) + .20($900,000)] / 1.13 = $796,460

Since Dietrich owes its bondholders $1,200,000 at the end of the year, its stockholders will receive$1,500,000 (= $2,700,000 1,200,000) if the expansion continues. If there is a recession, itsstockholders will receive nothing since the firms bondholders have a more senior claim on all $1,100,000of the firms earnings. So, the market value of Dietrich's equity is: S

Dietrich = [.80($1,500,000) + .20($0)] / 1.13 = $1,061,947

Dietrich's bondholders will receive $1,200,000 if the expansion continues and $1,100,000 if there is arecession. So, the market value of Dietrich's debt is:


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BDietrich

= [.80($1,200,000) + .20($1,100,000)] / 1.13 = $1,044,248 b.The value of the company is the sum of the value of the firm's debt and equity. So, the value of Steinbergis: V

Steinberg = B + S

VSteinberg

= $796,460 + 1,309,735

VSteinberg = $2,106,195 And value of Dietrich is: V

Dietrich = B + S

VDietrich

= $1,044,248 + 1,061,947

VDietrich = $2,106,195 You should disagree with the CEO's statement. The risk of bankruptcy per se does not affect a firm'svalue. It is the actual costs of bankruptcy that decrease the value of a firm. Note that this problemassumes that there are no bankruptcy costs

Worksheet Difficulty: Intermediate


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Documents

Corporate Finance - Chapter 16 and 17