ACF 103 Fundamentals of Finance
ACF 103 – Fundamentals of Finance
Tutorial 10 – Questions
Chapter 16
1. FJM International is planning to finance a $20 million capital improvement program with half debt and half common stock. New shares can be sold for $25 a share, and the debt will carry a 12% interest rate. FJM currently has an all-equity capital structure with 1 million shares outstanding. If the firm has a 50% tax rate, and expects an EBIT of $5 million, earnings per share will be ______.
A. $1.20
B. $1.36
C. $1.78
D. $1.90
2. McIndustries currently has 500,000 shares of common stock outstanding at a market price of $40 a share, and $10 million in 8% bonds. The company needs to raise $10 million in order to implement a series of investment projects. This amount can be raised by either (1) issuing 250,000 new shares of common at $40 a share, or (2) selling bonds with a 10% yield. If the firm's tax rate is 50%, and the EBIT with the new projects is projected at $4 million, which alternative will result in the highest earnings per share?
A. debt
B. common stock
C. both alternatives will result in the same EPS
D. cannot tell without additional information
3. Text book Ch 16, problem # 1 (p.444)
4. Text book Ch 16, problem # 2 (p.444)
Homework problem
5. Lincoln Manufacturing has fixed costs (e.g., depreciation) of $40,000 directly attributable to producing Bingos. Bingos sell for $2 a unit and variable costs are $1.20 per unit.
a. What is the break-even point in units produced?
b. If the firm sold 100,000 units last year and expects volume to increase by 10%, what percentage increase in profits would Lincoln see with this increase in volume?
c. What is the Degree of Operating Leverage (DOL) at 100,000 units? At 110,000 units?
6. The Blue Boat Company currently has 2 million shares of common stock outstanding, along with $5 million in 10% bonds. The firm is considering a $10 million expansion program which will be financed with either
(1) all common stock at $50 a share, or
(2) all bonds at a 12% interest rate.
If the projected level of EBIT is $4 million and the firm's tax rate is 40%, which alternative will yield the higher EPS?
7. The Grey Gauge Company currently has 500,000 shares of common stock outstanding in addition to $5 million in 8% bonds. The company is considering a $5 million expansion program which can be financed with
(1) all common stock at $20 a share, or
(2) all bonds at 10% interest.
If the most likely EBIT for the firm will be $2.5 million, compute the EBIT-EPS indifference point and use it to determine which financing method would be preferred. Assume a 50% tax rate.
8. Eagle Corporation makes buses. During the past year, it earned $1 million after taxes. It has a 50% tax rate, no debt or preferred stock, and 250,000 shares of common stock outstanding. At the beginning of the year, the company will raise $1 million in debt at an interest rate of 10%. To what level would EBIT have to change in order for EPS to be the same as before the debt financing? What percentage of a change to EBIT does this represent?
Chapter 17
1. Good Souls Hospital pays no corporate taxes. It has a net operating income of $1 million and no debt in its capital structure. The market value of its common stock is $10 million. Suppose the hospital decided to borrow $2 million in long-term debt at an interest rate of 8% in order to retire some of its common stock. Compute the market value of the hospital using the net operating income and traditional approaches to valuation. Explain your results.
2. Alpha and Beta are identical firms in every respect except for capital structure. Alpha has 60% debt and 40% equity. Beta has 40% debt and 60% equity. Capital markets are perfect, the borrowing rate for each is 12%, and there are no taxes. If you own 1% of each company, and if each has net operating income of $400,000, what is your dollar return for each firm if the overall capitalization rate is 20%? What is the implied equity capitalization rate?
3. Hangzhou Rubber Company and Zhengzhou Tyres Inc., are identical except for capital structures. Hangzhou has 50% debt and 50% equity financing, whereas Zhengzhou has 20% debt and 80% equity financing. (All percentages are in market value terms.) The borrowing rate for both companies is l3% in a no-tax world, and capital markets are assumed to be perfect. The earnings of both companies are not expected to grow, and all earnings are paid out to shareholders in the form of dividends.
a. If you own 3% of the common stock of Hangzhou, what is your dollar return if the company has net operating income of $360,000 and the overall capitalization rate of the company, ko, is 18%? What is the implied equity capitalization rate, ke?
b. Zhengzhou has the same net operating income as Hangzhou. What is the implied equity capitalization rate of Zhengzhou? Why does it differ from that of Hangzhou?
4. Text book Ch 17, problem # 3 (p.470)
Note: For part (b), prepare a table (in two parts) with the data in it – do not draw the graph. The column headings should be:
Part 1 # shares B EBIT I EBT EAT
Part 2 ki EPS P ke = EPS/P S = (# shares) × P V = B + S
Homework problem
5. Text book Ch 17, problem # 4 (p.470)
6. Li Na Corporation has earnings before interest and taxes of $6 million and a 40% tax rate. It is able to borrow at an interest rate of 14%, whereas its equity capitalization rate in the absence of borrowing is 18%. The earnings of the company are not expected to grow, and all earnings are paid out to shareholders in the form of dividends. In the presence of corporate but no personal taxes, what is the value of the company in an M&M world with no financial leverage? With $8 million in debt? With $14 million in debt?
7. A firm with no debt has a current market value of $100 million. It borrows $10 million at 8%. Management estimates the present value of associated bankruptcy and agency costs at $2 million. If the company's tax rate is 35%, what is its new market value?
1
ACF 103 HAUT 2015 tutorial 10