Reference no: EM13499324

1.Apple Computer has no debt. As Problem 21 in Chapter 15 makes clear, by issuing debt Apple can generate a very large tax shield potentially worth over $10 billion. Given Apple’s success,one would be hard pressed to argue that Apple’s management are naïve and unaware of this huge potential to create value. A more likely explanation is that issuing debt would entail other costs. What might these costs be?

2.Hawar International is a shipping firm with a current share price of $5.50 and 10 million shares outstanding. Suppose Hawar announces plans to lower its corporate taxes by borrowing $20 million and repurchasing shares.

a. With perfect capital markets, what will the share price be after this announcement? Suppose that Hawar pays a corporate tax rate of 30%, and that shareholders expect the change in debt to be permanent.

b. If the only imperfection is corporate taxes, what will the share price be after this announcement?

c. Suppose the only imperfections are corporate taxes and financial distress costs. If the share price rises to $5.75 after this announcement, what is the PV of financial distress costs Hawar will incur as the result of this new debt?

3.Your firm is considering issuing one-year debt, and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt:

Suppose the firm has a beta of zero, so that the appropriate discount rate for financial distress costs is the risk-free rate of 5%. Which level of debt above is optimal if, in the event of distress,the firm will have distress costs equal to

a. $2 million?

b. $5 million?

c. $25 million?

4.Marpor Industries has no debt and expects to generate free cash flows of $16 million each year. Marpor believes that if it permanently increases its level of debt to $40 million, the risk of financial distress may cause it to lose some customers and receive less favorable terms from its suppliers. As a result, Marpor’s expected free cash flows with debt will be only $15 million per year. Suppose Marpor’s tax rate is 35%, the risk-free rate is 5%, the expected return of the market is 15%, and the beta of Marpor’s free cash flows is 1.10 (with or without leverage).

a. Estimate Marpor’s value without leverage.

b. Estimate Marpor’s value with the new leverage.

5.Real estate purchases are often financed with at least 80% debt. Most corporations, however,have less than 50% debt financing. Provide an explanation for this difference using the tradeoff theory.

6.On May 14, 2008, General Motors paid a dividend of $0.25 per share. During the same quarter GM lost a staggering $15.5 billion or $27.33 per share. Seven months later the company asked for billions of dollars of government aid and ultimately declared bankruptcy just over a year later,on June 1, 2009. At that point a share of GM was worth only a little more than a dollar.

a. If you ignore the possibility of a government bailout, the decision to pay a dividend given how close the company was to financial distress is an example of what kind of cost?

b. What would your answer be if GM executives anticipated that there was a possibility of a government bailout should the firm be forced to declare bankruptcy?

7.Dynron Corporation’s primary business is natural gas transportation using its vast gas pipeline network. Dynron’s assets currently have a market value of $150 million. The firm is exploring the possibility of raising $50 million by selling part of its pipeline network and investing the $50 million in a fiber-optic network to generate revenues by selling high-speed network bandwidth. While this new investment is expected to increase profits, it will also substantially increase Dynron’s risk. If Dynron is levered, would this investment be more or less attractive to equity holders than if Dynron had no debt?

8.Consider a firm whose only asset is a plot of vacant land, and whose only liability is debt of $15 million due in one year. If left vacant, the land will be worth $10 million in one year. Alternatively, the firm can develop the land at an upfront cost of $20 million. The developed land will be worth $35 million in one year. Suppose the risk-free interest rate is 10%, assume all cash flows are risk-free, and assume there are no taxes.

a. If the firm chooses not to develop the land, what is the value of the firm’s equity today? What is the value of the debt today?

b. What is the NPV of developing the land?

c. Suppose the firm raises $20 million from equity holders to develop the land. If the firm develops the land, what is the value of the firm’s equity today? What is the value of the firm’s debt today?

d. Given your answer to part (c), would equity holders be willing to provide the $20 million needed to develop the land?

9.Sarvon Systems has a debt-equity ratio of 1.2, an equity beta of 2.0, and a debt beta of 0.30. It currently is evaluating the following projects, none of which would change the firm’s volatility (amounts in $ millions):

a. Which project will equity holders agree to fund?

b. What is the cost to the firm of the debt overhang?

10.Zymase is a biotechnology start-up firm. Researchers at Zymase must choose one of three different research strategies. The payoffs (after-tax) and their likelihood for each strategy are shown below. The risk of each project is diversifiable.

a. Which project has the highest expected payoff?

b. Suppose Zymase has debt of $40 million due at the time of the project’s payoff. Which project has the highest expected payoff for equity holders?

c. Suppose Zymase has debt of $110 million due at the time of the project’s payoff. Which project has the highest expected payoff for equity holders?

d. If management chooses the strategy that maximizes the payoff to equity holders, what is the expected agency cost to the firm from having $40 million in debt due? What is the expected agency cost to the firm from having $110 million in debt due?