Financing Decisions in a Business Context

Financing Decisions in a Business Context

Exercises

Due dates for homework assignments will be given in class.

M&M without taxes.

1. Maurice Stanley Glass Company expects free cash flows of $426,000 in perpetuity. The unlevered required rate of return for this business is 14.2%. Stanley has 50,000 shares of common stock and $500,000 of riskless bonds outstanding. The company pays 100% of its cash flows to its investors. The riskless borrowing and lending rate is 7%. (16.11)

(a) Determine Stanley’s required rate of return on equity.

(b) Prepare the company’s market value balance sheet. What is the value of an individual share of common stock?

Stanley is considering two alternative capital structures. One alternative is to issue new common stock and use the proceeds to repurchase the $500,000 of bonds outstanding, leaving the company with an all-equity capital structure. The other alternative is to issue an additional $1 million of bonds and use the proceeds to repurchase common stock.

Market value of debt $0 $500,000 $1,500,000

Market value of equity

Market value of assets

Price per share of common stock

Debt/equity ratio

Equity required rate of return

Weighted average cost of capital

(d) Graph Stanley’s required rates of return (RB, RS and RWACC) as a function of the company’s debt/equity ratio. Graph the market value of Stanley’s assets as a function of the dollar amount of debt the company uses.

(e) Explain how the shapes of the functions in the required rates of return graph contribute to the share of the graph of the value of the company’s assets.

(f) Is Stanely’s choice of capital structure a crucial decision? Explain your answer.

2. Fonseca Formal Wear produces tuxedos sold to clothing rental firms operating in Northern Europe. This is a no-growth business so the company’s free cash flow is expected to be a perpetuity that depends only on economic conditions. The company’s expectations are given in the table below and it pays all available cash flows to investors. Fonseca is financed entirely by equity comprising 40,000 shares. The unlevered required rate of return is 8%, the riskless borrowing and lending rate is 4% and there are no taxes. (16.FFW)

Recession Expected Expansion

EBIT $10,000 $16,000 $20,000

(a) Prepare the company’s market value balance sheet for expected economic conditions. What is the price per share of common stock?

(b) The company is considering issuing $50,000 in riskless bonds and using the proceeds to repurchase common stock. Determine the

(c) Prepare Fonseca’s free cash flow and financial cash flow statements for each possible economic condition under both capital structures.

(d) How many shares of stock are outstanding under each capital structure? Determine the company’s dividends per share for each possible economic condition under both capital structures.

Vikram Chaterji is an important shareholder who has $6,000 of his own money invested in Fonseca’s common stock so the company’s CFO asked him about the change in capital structure the company was considering. Chaterji replied that the change was fine from his point of view but insisted he would not pay 1 cent more for the shares because he could construct exactly the same capital structure on his own if he wanted to. Prepare the following tables to illustrate Chaterji’s statement:

(e) A table that shows his net cash flow for each economic condition if the company makes the capital structure change and Chaterji maintains his $6,000 investment in the firm’s common stock.

(f) A table that shows his net cash for each economic condition if the company does not make the capital structure change but Chaterji borrows money himself (at the company’s debt/equity ratio) and adds the proceeds to his own $6,000 to invest in the company’s common stock.

(g) How do the cash flows in the two tables compare? How does the risk compare? Explain briefly.

M&M with taxes.

3. Shank Pharmaceuticals has the right to mine medicinal salts on public land in perpetuity. Shank uses the salt deposits to produce bath products. This business generates after-tax free cash flows of $650,000 per year with a required rate of return of 13.0%. The company pays 100% of its cash flows to investors. There are 100,000 shares of stock outstanding and no debt. The company’s tax rate is 35% and the rate of return on riskless borrowing and lending is 7%. (16.15)

(a) Determine the market value of a single share of Shank’s common stock.

The company is considering issuing $2 million of perpetual bonds at 7% interest to repurchase common stock.

(b) Determine the amount of the interest tax-shield provided by the $2 million of debt. What is the present value of these tax shields?

(d) How many shares of stock are outstanding after this change in capital structure? What is the price per share?

(e) What is the per-share value of the interest tax-shield? Add this amount to the company’s original stock price and compare your result to your answer to part (d).

(f) Who receives the interest tax-shield? Why?

Other Benefits & Costs of Debt.

4. Big Boy Pocket Knives (BBPK) produces commemorative knives sold at historical celebrations. Next year’s model will be the last because it is too difficult to find the skilled craftsmen to carve the handles and engrave the blades. This model will produce free cash flow of $27,000 in a strong economy and $9,500 in a weak one. The probabilities of a strong and a weak economy are 40% and 60%, respectively. BBPK will distribute its final cash flows to the company creditors and owners who are risk-neutral and require a 4% rate of return. The financial market is perfect. (16.23)

(a) Assume BBPK has 1,000 shares of stock outstanding and no debt. Determine the amount of cash flow the company will pay to its investors in a strong economy, a weak economy and on average.

(b) Prepare the company’s market-value balance sheet. What is the market price of an individual share of stock?

(c) Rework parts (a) and (b) assuming the company issues 4% bonds with a face value of $10,000 and uses the proceeds to repurchase common stock.

(d) Did the use of debt financing affect the price of BBPK’s common stock? Why or why not? Is the company’s choice of capital structure a crucial decision under these circumstances? Explain your answer.

5. Rework problem 4. Assuming Big Boy Pocket Knives must pay court costs of $2,000 if it is unable to pay its creditor’s claims in full.

6. Cowtown Leather Distributors’ free cash flow next year will be $125,000 in a strong economy and $47,000 in a weak one. These economic conditions are equally likely. Cowtown has ridden the western wear fad as far as it will bo and will distribute these cash flows to the company’s creditors and owners and go out of business. The company’s investors are risk-neutral with a required rate of return of 7%. The financial market is perfect. (16.25)

(a) Cowtown has 16,000 shares of stock outstanding and no debt. Determine the amount of cash flow it will pay to its investors in a strong economy, a weak economy and on average.

(b) Prepare the company’s market-value balance sheet. What is the market price of an individual share of stock?

(c) Rework parts (a) and (b) assuming the company issues 7% bonds with a face value of $50,000 and uses the proceeds to repurchase common stock. Assume also that the managers become so worried about repaying this debt in a weak economy that the company’s free cash flow falls from $47,000 to $32,000. There are no other costs of financial distress.

(d) Did the use of debt financing affect the price of Cowtown’s common stock? Why or why not? Is the company’s choice of capital structure a crucial decision under these circumstances? Explain your answer.

7. Passport Ocean Transport’s free cash flows and payments to investors one year from today under two investment strategies are shown below. The probabilities of a weak and strong economy are 85% and 15%, respectively. There are 1,000 shares of stock outstanding and investors are risk-neutral with a required rate of return of 5%. (16.27)

Conservative Strategy Aggressive Strategy

Weak Strong Weak Strong

Economy Economy Economy Economy

Free cash flow $10,500 $21,000 $0 $31,500

Paid to creditors 8,400 8,400 0 8,400

Paid to investors 2,100 12,600 0 23,100

Cash flow per share 2.10 12.60 0 23.10

(a) Determine the owners’ expected cash flow per share and the market price of an individual share of common stock under each investment strategy. Which investment strategy will the owners prefer? Why?

(b) Suppose the company’s senior managers own stock options with an exercise price of $7. What is their cash flow per option (cash flow per share – exercise price) in the following situations? Will they prefer the conservative strategy or the aggressive strategy? Compare their investment preferences to the owners’.

Conservative Strategy Aggressive Strategy

Strong economy ? ?

Weak economy ? ?

(c) Explain how the presence of a fixed-payment debt obligation affected the owners’ and managers preferences for a particular investment strategy.

8. Allison Classic Cars restores British sports cars from the 1960s. Their usual focus is on unique race and rally cars which by their nature are very expensive and so have a limited audience. Next year’s cash flows from their current project, restoring a Jaguar E-type race car, are given below.

Weak Strong

economy economy

Probability 0.39 0.61

Free cash flow $ 0 $1,300,000

(a) Prepare the company’s market value balance sheet. What is the value of its assets and common stock? What is the price per share? Investors are risk-neutral, the riskless return is 5%, the company has no debt and there are 25,000 shares outstanding.

Senior partner Richard Allison is troubled by the potential difficulty of selling the Jaguar and is considering a change in strategy for next year’s business. Specifically, he is considering the purchase of 20 MG Midgets for $10,000 each which the company can restore and sell next year for $7,500 each in a weak economy or $15,000 each in a strong one.

(b) What is the expected NPV of this investment project?

(c) Prepare the company’s market value balance sheet with the project. What is the value of its assets and common stock? What is the price per share? (The MG project is in addition to the Jaguar already under restoration.)

Allison is considering another change in strategy that, if adopted, will be implemented before purchasing the MGs. This change would be to borrow $150,000 for one year at 5% interest and use the proceeds to repurchase stock from other partners.

(d) How many shares of stock will Allison repurchase using the proceeds from the loan? How many will remain outstanding (fractional shares are possible)?

(e) Prepare the company’s market value balance sheet without and with the MG project assuming the company borrows the $150,000. What is the value of its assets, common stock and debt? What is the price per share?

The 4 scenarios considered in this problem are diagramed below

MG project

Debt No Yes

$ 0 1 2

150,000 3 4

(f) Explain why the stock price changed as it did with movement from:

i. Cell 1 to cell 2.

ii. Cell 1 to cell 3.

iii. Cell 3 to cell 4.

Incorporating Financing Effects in Investment Analysis.

9. Cathy Smith, President of Smith Canvas Products, noticed the problems shoppers have with plastic bags and decided to examine the possibility of producing reusable canvas ones. She didn’t want the company to be distracted from its core business of manufacturing canvas products for industrial applications, however. Therefore, Cathy instructed the project team to assume the company will take five years to build the business and then sell it to one of several companies that produce canvas products for consumers. The project team’s after-tax cash flow forecasts are given below. The full amount of the principal of the loan is due in five years although interest, at 8%, must be paid annually. The riskless required return is 6%, the required rate of return for this line of business is 12.8% and Smith Canvas Products’ tax rate is 35%. (17.15)

Time Free Cash Flow

0 $-750,000

1 -75,000

2 50,000

3 100,000

4 125,000

5 1,075,000*

*Includes anticipated proceeds from selling the business at the end of year 5.

Determine the canvas grocery bag project’s APV. Should Smith Canvas Products develop and then sell this business?

10. Beauti-Home Wallpaper Co. is considering an expansion of its operations into window treatments including draperies, blinds and shades. The project’s cash flows are given below. A minority business development agency will guarantee a loan of $800,000 to Beauti-Home to partially finance this project. The agency charges a one-time fee of 1.5% for this service. The interest rate on the guaranteed loan is 8% in comparison to 10% on a market loan. The company will use internal equity for the remainder of its financing. Beauti-Home’s business risk required rate of return is 13% and its tax rate is 34%. (17.16)

Time Free Cash Flow

0 $-1,500,000

1 300,000

2 400,000

3 500,000

4 500,000

5 450,000

(a) Determine the value of the expansion project’s free cash flows. Is this a viable investment without considering its financial side effects?

(b) How much must the company borrow under the guaranteed loan program to obtain proceeds of $800,000?

(d) Prepare the loan’s amortization schedule.

(e) Determine the value of the loan guarantee.

(f) Determine the value of the interest tax-shield.

(g) Determine the project’s APV. Should Beauti-Home expand its product line?

Weighted average cost of capital.

11. The companies listed below are in the 35% tax bracket. The rates of return on the riskless asset and the market portfolio are 6% and 14%, respectively. (17.25)