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FIN 300 – Homework Assignment #4

Due by 11.59pm on April 11

This homework assignment is to be submitted electronically via Canvas. If you feel that a question
misses essential information, make a reasonable assumption and clearly state that assumption.
No late homework will be accepted. You are allowed to – and I encourage you to – work together
on homework assignments. However, you must hand in your own individual homework.
Photocopies (or any other form of copies such as pictures taken of someone else’s homework)
are unacceptable. You must show how you obtained all your answers. Homework assignments
are graded pass (1) / fail (0): to pass, you have to attempt 100% of the homework assignment.

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Chapter 13 Problems

#1. You are a senior manager at an automobile company. In an effort to offer a full menu of auto
and gas products, your firm is considering an oil exploration project. The CEO has selected the
manager of the company’s truck division to oversee the project, and has asked you to evaluate
whether the company should proceed with the exploration or not.

To help you evaluate the project, your associate gives you the following information:

Company Equity Beta D/(D+E)


General American Oil 1.81 0.03
Lousiana Land & Exploration 1.29 0.12
Mesa Petroleum 2.36 0.37
Murphy Oil 1.60 0.27
Natomas Oil 1.84 0.41
Oceanic Exploration 1.53 0.23
Superior Oil 1.35 0.16
With D = debt, E = equity.

a.) Should you also ask the associate for similar information on car manufacturers? On truck
manufacturers? On automobile companies? On your firm in particular? Why or why not?

b.) Based on the information you have available, calculate an appropriate discount rate assuming
that risk free rate is 4%, the expected market return is 8%, and the corporate tax rate Tc is 0.
Assume that the debt of the companies your associate looked at is risk free. Assume that the oil
exploration project is 100% equity financed

#2. Calgary Industries, Inc., is considering a new project that costs $25 million. The project will
generate after-tax cash flows of $7 million for five years starting one year after the initial
investment. The firm has a debt-to-equity ratio of 0.60. The cost of equity is 15 percent and the
cost of debt is 9 percent. The corporate tax rate is 35 percent. It appears that the project has the
same risk of the overall firm and will be financed the same as the overall firm. Should Calgary
take on the project?

Chapter 16 Problems

#3. Spartan Corp. and Wolverine Corp. are identical in all respects except capital structure.
Spartan's bonds have a market value of $400 million while Wolverine's bonds have a market
value of $200 million. These firms operate in a perfect world where markets are perfectly
efficient and there are no taxes or financial distress/bankruptcy costs. Both firms have 10 million
shares outstanding. If the stock price for Spartan is $80, what do you predict for the stock price
of Wolverine? [Hint: Use Modigliani and Miller]

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#4. A firm currently has no debt. The firm has 10 million shares outstanding and those shares
currently have a market price of $30 per share. The firm is contemplating selling $50 million in
bonds and using the proceeds to repurchase shares of stock. If they undertake this action, the
firm intends to keep this level of debt financing for the foreseeable future.

Assume first that there are no taxes. Given this data, if the firm announces that they will sell the
bonds and repurchase equity what:
(a) do you expect the stock price to be immediately after the announcement?
(b) will be the firm’s total market value of equity immediately after the announcement?
(c) do you expect the stock price to be after the bond issue/repurchase are completed?
(d) will be the firm’s total market value of equity after the bond issue/repurchase are completed?

Assume next that the corporate tax rate is 40%. Given this data, if the firm announces that they
will sell the bonds and repurchase equity what:
(e) do you expect the stock price to be immediately after the announcement?
(f) will be the firm’s total market value of equity immediately after the announcement?
(g) do you expect the stock price to be after the bond issue/repurchase are completed?
(h) will be the firm’s total market value of equity after the bond issue/repurchase are completed?

#5. A firm currently is an all equity firm with a market value of $600,000,000. The firm is
contemplating dramatically increasing its leverage by selling $150,000,000 in bonds and using
the proceeds to repurchase equity. The bonds promise a 10% interest payment at the end of each
year. The bonds are structured so that the firm will pay exactly $50,000,000 of the principal
back at the end of the third year, sixth year, and ninth year, and thus the bonds will be fully
retired at the end of the ninth year. The corporate tax rate is 30% and there are no personal taxes.
What will the market value of the firm be the moment after this deal is announced?

Chapter 17 Problems

#6. Caldor, a retailing chain in the northeast, filed for bankruptcy in September 1995. Shortly
after the bankruptcy its stock traded at $5.25 per share, down from about $20 per share earlier in
the year. How much of this drop in stock price should be attributed to bankruptcy costs -- all, part,
or none? Explain.

#7. Good Time Co. is a regional chain department store. It will remain in business for one more
year. The estimated probability of a boom next year is .60 and the estimated probability of a
recession is .40. It is projected that Good Time will have a total cash flow of $250 million in a
boom year and $100 million in a recession. Good Time’s required debt repayment next year is
$150 million. The firm has few fixed assets, so after next year is over the firm’s assets will be
liquidated for $0. Assume also that investors are risk-neutral and that interest rates are zero (i.e.,
no discounting is necessary). There are no taxes.
(a) Assuming that there were no financial distress costs or bankruptcy costs, calculate the market
value of Good Time’s (i) equity and (ii) debt.
(b) If the market value of equity is actually $60 million and the market value of debt is actually
$125 million, what is the market’s estimate of financial distress/bankruptcy costs?
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#8. Franklin Corporation estimates that there is 25% chance of a recession economy next year, a
50% chance of a normal economy next year, and a 25% chance of a boom economy next year.
The corporation will exist until the end of next year and then it will cease to exist. Franklin has
$80 of debt that must be repaid next year. Assume a 0% discount rate for all cash flows (in other
words, there is no discounting).

(a) Franklin has a low risk project that yields a cash flow of $70 in a recession, $100 in a normal
economy, and $130 in a boom. If Franklin chooses this low risk project:
(i) what is the value of Franklin’s debt?
(ii) what is the value of Franklin’s equity?

(b) Franklin has a high risk project that yields a cash flow of $30 in a recession, $100 in a normal
economy, and $160 in a boom. If Franklin chooses this high risk project:
(i) what is the value of Franklin’s debt?
(ii) what is the value of Franklin’s equity?

(c) Which project will Franklin choose? Given your answers to (a) and (b), when Franklin sells
the bonds would it like to include a covenant that would prohibit it from taking the high-risk
project? Explain your answer.

#9. A firm currently has equity with a market value of $500 million and debt with a market
value of $500 million. The firm has 10 million shares outstanding. The bonds offer investors a
return of 8%. The firm is contemplating issuing $250 million in new equity and using the
proceeds to repurchase $250 million of the firm's debt. The corporate tax rate is 35%, the
effective personal tax rate on equity income is 10% and the effective personal tax rate on interest
income is 20%. [Hint: This is similar to previous exercises and examples except here you are
decreasing debt and increasing equity. This is opposite of what we have done in examples in the
past. The same formulas apply in terms of the tax benefits of debt financing, but the signs will
be reversed.]
(a) What will the firm's stock price be immediately after the firm announces its
refinancing plan?
(b) How many shares will the firm issue?
(c) What is the market value of the firm's (i) debt and (ii) equity immediately before the
refinancing plan is announced?
(d) Calculate the market value of the firm's (i) debt and (ii) equity immediately after the
refinancing plan is announced (but before it is actually executed).
(e) Calculate the market value of the firm's (i) debt and (ii) equity after the equity issue
and bond repurchase are completed.