FIN534 - Corporate Finance - 46180

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1. You are an entrepreneur starting a biotechnology firm. If your research is successful, the
technology can be sold for $30 million. If your research is unsuccessful, it will be worth nothing.
To fund your research, you need to raise $2 million. Investors are willing to provide you with $2
million in initial capital in exchange for 50% of the unlevered equity in the firm.
a. What is the total market value of the firm without leverage?
b. Suppose you borrow $1 million. According to MM, what fraction of the firm’s equity will
you need to sell to raise the additional $1 million you need?
c. What is the value of your share of the firm’s equity in cases (a) and (b)?

 

2. Wolfrum Technology (WT) has no debt. Its assets will be worth $450 million in one year if the
economy is strong, but only $200 million in one year if the economy is weak. Both events are
equally likely. The market value today of its assets is $250 million.
a. What is the expected return of WT stock without leverage?
b. Suppose the risk-free interest rate is 5%. If WT borrows $100 million today at this rate and
uses the proceeds to pay an immediate cash dividend, what will be the market value of its
equity just after the dividend is paid, according to MM?
c. What is the expected return of MM stock after the dividend is paid in part (b)?

 

3. Global Pistons (GP) has common stock with a market value of $200 million and debt with a value
of $100 million. Investors expect a 15% return on the stock and a 6% return on the debt. Assume
perfect capital markets.
a. Suppose GP issues $100 million of new stock to buy back the debt. What is the expected
return of the stock after this transaction?
b. Suppose instead GP issues $50 million of new debt to repurchase stock.
i. If the risk of the debt does not change, what is the expected return of the stock after this
transaction?
ii. If the risk of the debt increases, would the expected return of the stock be higher or
lower than in part (i)?

 

4. Grommit Engineering expects to have net income next year of $20.75 million and free cash flow
of $22.15 million. Grommit’s marginal corporate tax rate is 35%.
a. If Grommit increases leverage so that its interest expense rises by $1 million, how will its net
income change?
b. For the same increase in interest expense, how will free cash flow change?

 

5. Your firm currently has $100 million in debt outstanding with a 10% interest rate. The terms of
the loan require the firm to repay $25 million of the balance each year. Suppose that the
marginal corporate tax rate is 40%, and that the interest tax shields have the same risk as the
loan. What is the present value of the interest tax shields from this debt?

 

6. Milton Industries expects free cash flow of $5 million each year. Milton’s corporate tax rate is
35%, and its unlevered cost of capital is 15%. The firm also has outstanding debt of $19.05
million, and it expects to maintain this level of debt permanently.
a. What is the value of Milton Industries without leverage?
b. What is the value of Milton Industries with leverage?

 

7. With its current leverage, Impi Corporation will have net income next year of $4.5 million. If
Impi’s corporate tax rate is 35% and it pays 8% interest on its debt, how much additional debt
can Impi issue this year and still receive the benefit of the interest tax shield next year?

 

 

Solution Description

1. You are an entrepreneur starting a biotechnology firm. If your research is successful, the
technology can be sold for $30 million. If your research is unsuccessful, it will be worth nothing.
To fund your research, you need to raise $2 million. Investors are willing to provide you with $2
million in initial capital in exchange for 50% of the unlevered equity in the firm.
a. What is the total market value of the firm without leverage?
b. Suppose you borrow $1 million. According to MM, what fraction of the firm’s equity will
you need to sell to raise the additional $1 million you need?
c. What is the value of your share of the firm’s equity in cases (a) and (b)?

 

2. Wolfrum

Attachments
FIN534 - Solutions to Chapter 14 (Problems 2, 4, & 14) and Chapter 15 (Problems 2, 5, 16, & 25).pdf
FIN534 - Soluti...