Corporate Finance Questions
Question 1
[5 points] True/False and Explain:
Ira says that investors prefer dividends to share repurchases as long as corporate tax rates are higher than personal income tax rates. If true, explain and provide an example to support your argument. If false,explain and provide an example to support your argument.
Question 2
[5 points] True/False and Explain:
Matteo says that a firm that increases its leverage will always increase its equity share price due to increased debt tax shields. If true, explain and provide an example to support your argument. If false, explain and provide an example to support your argument.
Question 3 [5 points] True/False and Explain:
Ramsey says all investors prefer share repurchases to dividends. If true, explain and provide an example to support your argument. If false,explain and provide an example to support your argument.
Question 4 [5 points] True/False and Explain:
Piyawit claims that if Firm A has a lower credit rating than Firm B, then Firm A has a higher debt- to-equity ratio than Firm B. If true, explain and provide an example to support your argument. If false, explain and provide an example to support your argument.
Question 5 [5 points] True/False and Explain:
Iina thinks that if the net present value of Firm A’s debt tax shields are greater than the net present value of Firm B’s debt tax shields, then it must be the case that Firm A pays greater interest payments than Firm B (assuming both firms have the same corporate tax rate). If true, explain and provide an example to support your argument. If false, explain and provide an example to support your argument.
Question 6 [5 points] True/False and Explain:
Khaleel says that if a firm’s marginal tax rate increases, then its equity beta could decrease. If true, explain and provide an example to support your argument. If false,explain and provide an example to support your argument.
Question 7 [30 points]
Suppose you helping your boss, Amyeline, value the mobile messaging startup Whazzup Inc. today (assume today’s date is January 1, 2016). The startup requires 4 rounds of financing over the next nine years: $2 million today, $3 million in two years, $3 million in 4 years, and $1 million in 7 years. If successful, then the company will be sold to another company for $1.2 billion in 9 years; the probability of such an outcome is 45%. If the company does not get acquired, it will be worth 0. The founders of the company initially allocate 1,000,000 shares to themselves, with an option pool of 750,000 shares to give to future employees. Assume that investors have a required rate of return of 20% for companies like Whazzup Inc.
. a)Provide the share price of the startup in each round of financing and the number of shares issued to investors in each round.
. b) How do your answers to part a) change if the acquisition price is only $900 million (assume all other information in the problem stays the same)? provide one sentence explaining intuition for how the results change.
. c) How do your answers to part a) change if the discount rate is 30% (assume all other information in the problem stays the same; for example, the exit value is back to the original acquisition price of $1.2 billion).Provide one sentence explaining intuition for how the results change.
. d) How do your answers to part a) change if option pool increases by 200,000 shares (assume all other information in the problem stays the same; for example, the exit value is back to the original acquisition price of $1.2 billion and the discount rate is 20%). Provide one sentence explaining intuition for how the results change.
Question 8 [15 points]
As of today (January 1, 2016), Anais Inc. has outstanding debt of $200 million (and interest payments to debt holders are perpetual), while its outstanding equity is worth $300 million. The firm generates perpetual free cash flows of $50 million. If the firm’s cost of debt is 5%, what is the present value of the firm’s debt tax shields? Assume the firm faces a tax rate of 34%, and that all cash flows occur at the end of the year.
If there is not enough information to calculate this value, explain why, and describe the information you would need in order to calculate this value.
Question 9 [30 points]?Today’s date is January 1, 2016. The projected annual income statement for the Yessen
Company is as follows:
Revenues Operating costs EBITDA Depreciation EBIT?Interest Expense Taxes?Net income
80,000/year 20,000/year 60,000/year
-10,000/year 50,000/year 5,000/year
-20,000/year 25,000/year
The firm expects to generate these figures in perpetuity (forever). Assume all cash flows are realized at the end of the year, and that the firm has 50,000 shares of equity outstanding.
. a) If the firm maintains a constant debt-to-equity ratio of 30% every year, with a cost of debt equal to the risk-free rate (4%) and the cost of equity equal to 12%. what would be the value of the firm today using the APV method? What would be the firm’s share price? What is the present value of the debt and equity of the firm? What is the present value of the firm’s tax shields?
. b) If the firm were to perform a leveraged recapitalization, and increase its debt-to-equity ratio to 50% (so the cost of debt would now be 6%), what would be the firm’s new valuation and new equity share price? How many shares of equity would be outstanding after the transaction (assume any cash payments from the firm to shareholders take the form of share repurchases)? Please use the APV method.
. c) If the firm were to reduce its debt-to-equity ratio to 10% by issuing shares (with an effective cost of debt of 4%), what would be the firm’s share price and how many shares would be outstanding? Please use the APV method.
Question 10 [30 points]
Today is January 1, 2016. You are helping Max make 10-year cash flow projections for a project in the electronics industry. The machinery needed for the project costs $2.5 million, and according to the tax authority, is depreciated using the straight line method over seven years. You can operate the machinery for 10 years (even though you can only claim depreciation expense for seven years). The pre-tax salvage value of the machinery at the end of the 10 years is $350,000. The purchase of the machinery is made today. You also expect to incur additional capital expenditures of $1.2 million for new computer equipment on December 31, 2022. This equipment is depreciated using the straight line method over three years, and has no salvage value.
The revenues from the project are expected to be $11 million first starting on December 31, 2016, and are expected to grow at a rate of 2% per year. Labor is expected to cost approximately $1.1 million every year, while COGS are estimated to be 30% of revenues each year.
The net working capital required for the project is given by the following data: cash on hand in a given year is estimated to be approximately 2% of annual revenues. Days sales outstanding will be 30 days (out of a 360 day cycle), while days payable outstanding will be 45 days (out of a 360 day cycle). Inventory will be 5% of COGS each year. Assume net working capital is 0 as of today, and fully recovered by the end of the project (on December 31, 2025).
The cost of financing for the project can be inferred from the following data. Analysts estimate that the typical cost of debt for electronics projects is approximately 5.3%. The projected beta of equity for the project is 1.20, and the firm is planning to maintain a constant debt-to-equity ratio (in market values) of 0.20. Using expert forecasts for stock market returns, you believe that the annual expected return for the entire market will be 8% for the next 10 years, and that the risk- free rate will be projected to remain at 3% over the entire life of the project. Assume a marginal tax rate of 34%, and that any tax loss can be carried forward indefinitely.
. a) [15 points] Forecast the cash flows from the project. (January 1, 2016 till December 31, 2025)
. b) [10 points] Calculate the WACC
. c) [5 points] Calculate the NPV of the project.
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