Reference no: EM132576381

1. Consider a project with free cash flow in one year of $130,000 or $180,000, with each outcome being equally likely. The initial investment required for the project is $100,000, and the project's cost of capital is 20%. The risk-free interest rate is 10%.

a. What is the NPV of this project?

b. Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. The equity holders will receive the cash flows of the project in one year. How much money can be raised this way - that is, what is the initial market value of the unlevered equity?

c. Suppose the initial $100,000 is instead raised by borrowing at the risk-free interest rate. What are the cash flows of the levered equity, and what is its initial value according to M&M?

2. HH Industries has 50 million shares that are currently trading for $4 per share and $200 million worth of debt. The debt is risk free and has an interest rate of 5%, and the expected return of HH stock is 11%. Suppose a strike causes the price of HH stock to fall 25% to $3 per share. The value of the risk-free debt is unchanged. Assuming there are no taxes and the risk of HH's assets is unchanged, what happens to HH's equity cost of capital?

3. Tally Inc is an all-equity firm with assets worth $25 billion and 10 billion shares outstanding. Tally plans to borrow $10 billion and use these funds to repurchase shares. The firm's marginal corporate tax is 35%, and Tally plans to keep its outstanding debt equal to $10 billion permanently.

a. Without the increase in leverage, what would Tally's share price be?

b. Suppose Tally offers $2.75 per share to repurchase its shares. Would shareholders sell for this price?

c. Suppose Tally offers $3.00 per share, and shareholders tender their shares at this price. What will Tally's share price be after the repurchase?

d. What is the lowest price Tally can offer and have shareholders tender their shares? What will its stock price be after the share repurchase in that case?

4. Corwin International is a shipping firm with a current share price of $5.50 and 10 million shares outstanding. Suppose Corwin announces plans to increase its leverage by borrowing $20 million and repurchasing shares.

a. With perfect capital markets, what will the share price be after this announcement?

Suppose that Corwin pays a corporate tax rate of 30%, and that the shareholders expect the increase in debt to be permanent.

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

c. Suppose the only market 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 Corwin will incur as the result of this new debt?