Reference no: EM13856801

Question 1:

Kurz Manufacturing is currently a levered firm with 50M shares outstanding priced at $10.00 per share and 250K bonds outstanding priced at $1,000 per bond (this is also the face value of each bond).

Investors expect these bonds to pay interest of 4 percent per year and this debt level to be held in perpetuity. Assume that Kurz is subject to a 25 percent corporate tax rate.

a) What is the market value of Kurz's existing assets?

b) The value of Kurz's assets consists of the value of operating assets and the value of the tax shield. What is the value of the tax shield and operating assets?

Kurz announces that tomorrow it will issue $100M worth of shares and use those funds to retire $100M worth of debt. Assume that the market did not expect this announcement.

c) What is the new price per share immediately following this announcement, but before the shares are issued or the debt is retired? (hint: the share price will decrease because of a change in the value of the tax shield)

d) What percentage of the firm's equity does Kurz have to sell to raise $100M?

Question 2:

Citing the slump in oil prices and heavy capital spending commitments, Moody's downgraded Transocean's (symbol: RIG) debt rating to "junk" status on February 25, 2015. Read this article for more information:

https://www.moodys.com/research/Moodys-downgrades-Transoceans-Rating-to-Ba1--PR_319210

You work for a consulting firm that specializes in asset valuation. You have been tasked with calculating Transocean's weighted average cost of capital with taxes (WACC with taxes) as a first step in calculating the value of Transocean's existing assets. You know that the long-term risk-free rate is currently 3 percent and that the market risk premium is 6 percent.

a) First, calculate the expected return on debt for Transocean. Because the Transocean credit rating has been downgraded to "junk", you may use the reported beta (use the three-year beta) of the SPDR Barclays High Yield Bond fund (symbol: JNK), which can be found on Yahoo! Finance.

b) Calculate the WACC with taxes for Transocean. Market capitalization, beta of equity, and book value of debt (use the most recent balance sheet) can all be found on Yahoo! Finance. Use the top marginal corporate federal tax rate as the tax rate in your calculation (and can be easily found doing online research). Report all of the numbers used to calculate the WACC with taxes.

Question 3:

You borrow $11M by issuing a par-value bond that has a 10-year maturity, promises an annual coupon payment of 5 percent, and has a face value of $10M. The expected return on this bond is also 5 percent.

a) What is the value of this bond, as determined by the present value of its future cash flows? Is the bond mispriced?

b) Assume a tax rate of 35 percent. What is the value of the tax shield generated by this bond?

c) What is the NPV of financing from issuing this bond? In this case, the NPV of financing will consist of the value of the tax shield and any value gained or lost from the bond being mispriced.

d) What is the value of the tax shield generated by an identical bond that is issued in perpetuity? (this should be a very quick calculation)

Question 4:

Suppose that your firm consists of $50M in cash. Specifically, your firm consists of $10M in debt (issued in perpetuity) and $40M in equity. You announce that you will take this $50M in cash and invest it into a project that will produce expected after-tax free cash flows of $12.5M in perpetuity. Assume a tax rate of 30 percent. You would like to value this project (and hence your firm) by utilizing the weighted average cost of capital with taxes.

Assume throughout the problem that the correct expected return on equity is 20 percent and the correct expected return on debt is 5 percent.

a) Based on the numbers given in the problem, calculate the WACC with taxes.

b) Using the WACC with taxes, calculate the value of the firm.

You might have noticed that the value of the firm that you calculated in (b) is inconsistent with the value of the firm you used to calculate the WACC with taxes ($50M) in part (a). That is, the WACC with taxes you used to value the firm not internally consistent with the value of the firm used to calculate WACC with taxes. This is a problem when you use WACC with taxes to calculate the value of a project and the project in turn significantly affects the inputs for calculating WACC with taxes.

c) What is the correct firm value and WACC with taxes?

Hint: you will have to "guess" a value for the firm and calculate WACC with taxes (keep in mind that the value of debt will always equal $10M). Then, using this WACC with taxes, calculate the value of the firm by applying the WACC with taxes to the $12.5M perpetuity. If this calculated value equals your "guess", then you have the correct value of the firm and WACC with taxes. If it does not equal your guess, you will have to try again until the calculated value equals your guess. Microsoft Excel, particularly the Solver function, might be useful when answering this question.