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Posted: February 5th, 2019

MBA570_Homework_7

Instructions: Either type or
write your answers directly on this document and submit the completed
assignment to your ESO. Show your work
for the calculations. If you use additional documents for the calculations,
label them with your name and course number (MBA 570) and submit them as well.
Each question is worth 10 points.

1.
Consider a project with free cash
flows in one year of $141,799 or $181,108, with each outcome equally likely.
The initial investment required for the project is $60,000, and the project’s
cost of capital is 20%. The risk-free interest rate is 6% :

a.
The
NPV for this project is $__________. (Round
to the nearest dollar.)

b.
Suppose
that to raise the funds for the initial investment, the project is sold to
investors as an all-equity firm. The equity holders will receive the cash flows
of the project in one year. How much money can be raised this way? In other
words, the initial market value of the unlevered equity is $__________. (Round to nearest dollar.)

c.
Suppose
the initial $60,000 is instead raised by borrowing at the risk-free investment
rate. The cash flows of the levered equity and its initial value according to
MM are (fill in the table below rounding
to the nearest dollar):

Date 0

Date 1

Initial Value

Cash Flow
Strong Economy

Cash Flow
Weak Economy

Debt

$60,000

$__________

$__________

Levered Equity

$__________

$__________

$__________

2.
Acort
Industries owns assets that will have a 60% probability of having a market
value of $55 million in one year. There is a 40% chance that the assets will be
worth only $25 million. The current risk-free rate is 8%, and Acort’s assets
have a cost of capital of 16%.

a.
If
Acort is unlevered, the current market value of its unlevered equity is $__________
million. (Round to three decimal places.)

b.
Suppose
instead that Acort has debt with a face value of $21 million due in one year.
According to MM, the current market value of its levered equity is $__________
million. (Round to three decimal places.)

c.
The
expected return of Acort’s equity without and with leverage is (fill in the table below rounding to two
decimal places):

Expected
Return

Without
Leverage

__________%

With
Leverage

__________%

d.
The
lowest possible realized return of Acort’s equity without and with leverage is (fill in the table below rounding to two
decimal places):

Expected
Return

Without
Leverage

__________%

With
Leverage

__________%

3.
Suppose
Microsoft has no debt and an equity cost of capital of 9.5%. The average
debt-to-value ratio for the software industry is 12.8%. If Microsoft took on
the average amount of debt for its industry, the cost of its equity would be
__________%. (Round to two decimal
places.)

4.
Hubbard
Industries is an all-equity firm whose shares have an expected return of 10%. Hubbard
does a leveraged recapitalization, issuing debt and repurchasing stock, until
its debt-equity ratio is 0.54. Due to the increased risk, shareholders now
expect a return of 15%. Assuming there are no taxes and Hubbard’s debt is
risk-free, the interest rate on the debt is __________%. (Round to two decimal places.)

5.
Arnell
Industries has just issued $20 million in debt (at par). The firm will pay
interest only on this debt. Arnell/s marginal tax rate is expected to be 30%
for the foreseeable future.

a.
Suppose
Arnell pays interest of 10% per year on its debt. The annual interest tax
shield is $__________ million. (Round to three
decimal places.)

b.
The
present value of the interest tax shield is $__________ million. (Round to one decimal place.)

c.
Suppose
instead that the interest rate on the debt is 6%. In this case, the present
value of the interest tax shield is $__________ million. (Round to one decimal place.)

6.
Rogot
Instruments makes fine violins and cellos. It has $1.9 million in debt outstanding,
equity valued at $2.3 million, and pays corporate income tax at a rate of 31%.
Its cost of equity is 12% and its cost of debt is 6%.

a.
Rogot’s
pre-tax weighted average cost of capital is __________%. (Round to two decimal places.)

b.
Rogot’s
effective after-tax weighted average cost of capital is __________%. (Round to two decimal places.)

7.
Rumolt
Motors has 71 million shares outstanding with a share price of $25 per share.
In addition, Rumolt has issued bonds with a total current market value of $854
million. Suppose Rumolt’s equity cost of capital is 9% and its debt cost of
capital is 5%.

a.
Rumolt’s
pre-tax weighted average cost of capital is __________%. (Round to two decimal places.)

b.
If
Rumolt’s corporate tax rate is 40%, its after-tax weighted average cost of
capital is __________%. (Round to two
decimal places.)

8.
Milton
Industries expects free cash flow of $9 million each year. Milton’s corporate
tax rate is 40%, and its levered cost of capital is 13%. Milton also has
outstanding debt of $18.66 million, and it expects to maintain this level of
debt permanently.

a.
Milton
Industries’ value without leverage is $__________ million. (Round to two decimal places.)

b.
Milton
Industries’ value with leverage is $__________ million. (Round to two decimal places.)

9.
Markum
Enterprises is considering permanently adding an additional $112 million of
debt to its capital structure. Markum’s corporate tax rate is 35%.

a.
Absent
personal taxes, the value of the interest tax shield from new debt is $__________
million. (Round to two decimal places.)

b.
If
investors pay a tax rate of 35% on interest income, and a tax rate of 25% on
income from dividends and capital gains, the value of the interest tax shield
from new debt is
$__________ million. (Round to two
decimal places.)

10.
With
its current leverage, Arundel Corp. will have net income next year of $7
million. If Arundel’s corporate tax rate is 35%, and it pays 6% interest on its
debt, the additional debt Arundel can issue this year and still receive the
benefit of the interest tax shield next year is
$__________ million. (Round to three
decimal places.)

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