Reference no: EM131231351

Question 1 -

Hot Tissue Corp., a young, biotechnology firm, is considering an initial public offering of common stock. The company has no debt, and it expects total revenue next year of $40 million. Revenues are expected to grow at an annual rate of 4% indefinitely thereafter. Cash operating expenses are expected to come to 50% of total revenues each year. Annual research and development expenditures are expected to be 10% of annual revenue, annual depreciation is expected to be 10% of annual revenue, and annual capital expenditures are expected to be 5% of annual revenue. The company's tax rate is 35%. Although Hot Tissue currently has no publicly traded stock, the average beta for the stocks of comparable biotech firms is 1.25. The risk-free rate of return is 4% and the risk premium (market return minus risk-free rate) on the market portfolio is 8%.

a) What do you estimate the total discounted cash flow value of Hot Tissue to be?

b) Hot Tissue needs to invest $46.06 million now to realize the projected cash flows described in (a) above. Underwriting fees will total 6% of the issue, so the company will need to sell enough stock to raise a net total of $46.06 million, after underwriting fees. If investors valued the company the same way you did in part (a), what ownership share would the company have to sell in the initial public offering to raise a net $46.06 million?

c) Suppose in reality that Hot Tissue will have to sell a 65% share of the company's equity to the public in order to raise the needed $46.06 million. In that event, what will be the net present value for investors who participate in the initial public offering?

Question 2 -

Alpha Corporation has just paid its annual dividend and is looking forward to another successful year ahead. The company had free cash flow for the year just ended of $1 billion, all of which it just paid out to its shareholders as a dividend. Right now, shareholders do not believe that Alpha has any growth opportunities, so they expect the annual cash flow and dividend stream to remain unchanged for the foreseeable future. Alpha has 100 million shares outstanding and a market capitalization of $10 billion. The company is entirely equity-financed. The capital market is efficient.

a) Alpha's CEO now proposes that the company skip its dividend one year from now and instead invest the entire amount of the coming year's $1 billion free cash flow in a project that management believes will generate a perpetual annual rate of return of 21%. The CEO further asserts that the new project has similar risk to the company's assets in place. If the company were to announce immediately its plans for the investment one year from now (financed by skipping next year's dividend) what do you think will happen to Alpha's stock price?

b) Some of Alpha's Board members are worried that shareholders are expecting a dividend next year and that announcing plans to skip next year's dividend will lower the stock price today. Suppose Alpha were to announce instead that it plans to pay its usual dividend one year from now and that it has no plans for any new investment at T = 1. What will happen to the stock price today?

c) Suppose Alpha settles on a compromise: Alpha announces today that it will invest in the new project one year from now, but it will simultaneously issue enough new shares at that time to enable it to pay the usual $10 dividend per share to its existing shareholders. What do you think will happen to Alpha's share price one year from now under this plan? What do you think will happen to Alpha's stock price today? Which of the three plans do you think Alpha's shareholders would prefer?

Question 3 -

Stodgy Corp. has a debt-equity ratio (in market value terms) of 1/9. The beta of Stodgy's stock is 1.2. Stodgy's debt has a yield to maturity of 5%. The risk-free rate of return is 5%, and the risk premium on the market portfolio is 8%. The corporate tax rate is 35%.

a) What are Stodgy's cost of equity and weighted average cost of capital?

b) For a company with debt, we know that the cost of equity is given by:

R_S = R_F + β_L(R_M + R_F)

where β_L is the beta of the levered company's stock. If the same company were, instead, unlevered (i.e., it had no debt), its beta would be β_U, and its cost of equity, R₀, would be given by:

R₀ = R_F + β_U(R_M - R_F)

We also know that if a company's debt is risk-free, the relationship between its levered and unlevered cost of equity is given by:

R_S = R₀ + (B/S)(1-t_C)(R₀-R_F)

Using these three equations, derive the relationship between a company's levered beta (β_L) and its unlevered beta (β_U) when the company's debt is risk-free.

c) Using the relationship you have derived in (b), find Stodgy's unlevered beta, β_U, and the cost of equity it would have if it had no debt, R₀.

d) Now suppose that Stodgy's management suddenly decides that it could use a little more excitement. Specifically, it decides to increase Stodgy's debt-to-value ratio (in market value terms) to 80%. Using your answers to (b) and (c), find Stodgy's new levered cost of equity and its new weighted average cost of capital for the new capital structure. Can you cite any reasons why you should be cautious in using the new cost of capital figures that you have calculated?

Question 4 -

Fogey Corp. is conservatively managed. Outstanding debt is adjusted to maintain a constant ratio of debt to enterprise value of 10%. The beta of Fogey's equity is 1.25 and the beta of Fogey's debt is 0.25. The risk-free rate of return is 3%, and the expected risk premium on the overall market is 8%. Fogey is expected to generate annual free cash flow equal to $240 million each year for the foreseeable future. The corporate tax rate is 40%.

a) What is Fogey's weighted average cost of capital, rWACC, and what is its current enterprise value?

b) What is Fogey's unlevered cost of capital, rU?

c) Suppose now that a private equity firm buys all of Fogey's equity as part of a leveraged buyout. Fogey's debt remains the obligation of the company, and the newly-private company also issues enough new debt to raise Fogey's debt-to-enterprise value ratio to 50%. As a result, the beta of all of Fogey's debt goes to 0.4. What will be Fogey's new weighted average cost of capital, rWACC, after the buyout, and what will be its new enterprise value?