RSM333 - Assignment #2 - Fall 2011

You may work in groups of up to 3. Due 4pm at Rotman Commerce, December 2, 2011 40 MARKS TOTAL Question 1 - 10 marks
You plan to start a new business. The initial cost is $10,000 and the business will give you pre-tax cash flows of $1,950 per year in perpetuity. A friend of yours has started a very similar business and he is obtaining a return of 18.2% on the money he invested, however he has financed the investment half with his own money and half by taking a perpetual loan at the market rate of 8%. You would be more than satisfied by getting a comparable return, but are planning to completely finance the project yourself. The tax rate is 30% for both you and your friend. a) Should you start this business? (3 marks) b) Your friend has suggested you should take advantage of the tax deductibility of interest expenses by borrowing an amount such that your business is financing with a debt to equity ratio of ¼. Your interest rate would also be 8%. Should you start the project if you obtain the financing? (3 marks) c) Compute the amount of the loan you would need from the bank in part b. (2 marks) d) What practical limitations prevent the use of 100% debt financing to maximize the value of the firm? Give three examples of these costs (2 marks)

Question 2 - 10 marks
Mr Anderson Ltd. is considering a number of large, short-term projects which are expected to wrap up within 12 months of being initiated: PROJECT 1 2 3 4 5 6 INITIAL COST $30,000,000 $21,000,000 $8,000,000 $12,500,000 $25,000,000 $19,000,000 AFTER-TAX CASH FLOWS IN ONE YEAR $38,000,000 $24,000,000 $12,000,000 $14,000,000 $35,000,000 $21,100,000

The company’s current dividend is $2.25 per share, which management has carefully managed such that it has grown steadily at 6% each year. Its stock currently trades at $26 and there are 2 million shares outstanding. The company’s 100,000 preferred shares trade at $22 and collect dividends of $3. Cash and marketable securities on the company’s balance sheet total $30.5 million and the firm pays a tax rate of 30%. Their existing long-term debt (face value of $100,000,000, semi-annual payments) pays a 9.5% coupon (12 years remain before maturity) but current conditions would require a yield of 11% on any new issuance (the current yield to maturity). Floatation costs for new debt issues are estimated at 4% while new equity (common and preferred) can be issued at a cost of 7%. a) Assuming the firm wants to maintain its current capital structure, how much debt can Mr. Anderson take on before having to issue new equity? (2 marks) V = S + D + P = 52 + 22+ 90.261 = $164.26m Market value of debt = 100 b) Which projects should be initiated? (2 marks) Assume now the Mr. Anderson is not yet producing significant cash flows and lenders are concerned about the total amount of debt the company is incurring. If any more than $43 million worth of debt raised this year, the firm’s bond

10 marks Vulcan Tool and Die is a privately owned manufacturing firm serving its local market with an average of $10 million in yearly profits. and 20% of Enormous' assets value. a publically held manufacturing firm in a neighbouring province that serves the entire country. and in which all firms pay a 30% tax rate. electronics. the following three competitors (who also have risk-free debt) have been identified as having investments (business risk) similar to those of XYZ’s three divisions: Comparison Company A .Electronics C . c) Does this factor change your decision about any of the projects accepted in part b? (Hint: evaluate the alternatives of letting the bond rating fall vs.2 WD in their capital structure 0. The expected market return in 15% and the current risk-free interest rate is 7%. While Vulcan has no outstanding debt. Vulcan was forced to take a one-time write off $24 million in losses related to a failed expansion into another region. has three operating divisions: the foods. not letting it fall) (6 marks) Question 3 .3 0. As their market hasn't grown over the past few years. Industry commentators felt that Vulcan's management simply did not have the marketing know-how to penetrate new markets.2 0. Both firms are in a 30% tax bracket and Kirk pays an average rate of 6% on its outstanding debt.28 and its Price/Earnings ratio is 9. 30%. Kirk Solutions . the firm is financed 40% by risk-free debt.rating will fall and the yield to maturity on all of their bonds will rise to 14% (as would the required coupon on new bonds). and chemicals divisions account for 50%. Enormous Corp. Currently. respectively. the yield on preferred shares would not be affected however.10 marks Consider a world with no bankruptcy costs. a) What is the minimum amount of synergy benefits that Kirk expects to unlock by purchasing Vulcan? (5 marks) b) Identify (point-form) three synergistic benefits of combining the two firms (where is the "extra value" going to come from?) (3 marks) c) Which of the two firms owners' will generally end up with the majority of the value from the synergy benefits and why? (1 mark) d) Explain briefly why the owners of Vulcan would generally prefer to be paid the $115 million in cash instead of with $115 million of Kirk's stock. Kirk is leveraged such that its Debt/Equity ratio is 0. To help work out the divisional cost of capital.Food B . offered to buy Vulcan for $115 million in cash. (1 mark) Question 4 . Earlier this year.6 1. perfect capital markets. Last week.Chemicals Equity Beta 0. neither have Vulcan's profits.8 1.4 a) What is the cost of equity for each comparison firm? (3 marks) b) What is the cost of capital for each of Enormous' divisions? (3 marks) c) Calculate Enormous' WACC if the firm's managers decided to leverage the company by buying back stock with new debt until debt accounts for half of its capital structure (4 marks) .

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