Financing and Firm Valuation Flashcards
Assume a Company decides not to invest in a fully integrated, automated production line for new widgets. It relies instead on standard, less-expensive equipment, although the automated line is more efficient overall, according to a DCF calculation. Use real options insights to offer a brief explanation for why the firm is behaving that way.
The firm can be said to have created a put option. The standard equipment can likely be sold for more in the used equipment market than a customized, integrated system, and offers the firm the option to exit the investment at lower cost. This is not like the Enron call option discussed in class. Enron built a power plant and then mothballed it, waiting for higher electricity prices. Enron had a call option that it exercised when it activated the plant later. Here, the company does not wait to see future demand for widgets; instead it goes ahead now and produces widgets all the time, but with inefficient machines (even though the statement says that more value will be created with the standard machine despite it costing more). The explanation is that in so doing they have created (but not yet exercised) a valuable abandonment option.
Manana Enterprises is eligible for a subsidized 8-year loan of $8 million dollars at a 6 percent interest where the usual (non-subsidized) market rate is 12 percent. The company specializes in conducting English language courses to immigrants and became eligible for subsidized financing because the City of Dallas wants to encourage the company to teach English to the many Georgian immigrants that have recently moved to the city from the former Soviet republic. The loan is to be repaid in eight equal annual payments. What is the net present value of this loan? (assume no taxes).
The annual subsidized loan payment will by $X, such that 8,000,000=X*PVAF(8y,6%) ===> X=$1,288,245.
The true value of these payments is X*PVAF(8y,12%)=$6,400,001.
Hence, the present value of the subsidy is $8,000,000 minus $6,400,001 or $1,599,999.
The balance sheet of the BetaMax Company is given below. Assume that all balance sheet items are expressed in market values.
Assets Liabilities+Eq Cash 2,000 Debt 5,000 Inventory 2,000 Equity 5,000 PP&E 6,000 Total Assets $10,000 Total Liab.+Eq $10,000
The company has decided to distribute $2,000 to shareholders and is considering the following two ways to distribute the money to shareholders.
B. Issue $1,000 of new debt and $1,000 of new equity and use the proceeds to pay a dividend.
What impact will each of these 2 distribution approaches have on the following? Assume zero corporate and personal taxes.
- The risk of the asset-side of the balance sheet.
- The market value of (original) bondholders’ securities.
- The debt-to-firm value ratio (i.e., the leverage ratio).
- The market value of the firm.
B. Issue $1,000 of new debt and $1,000 of new equity and use the proceeds to pay a dividend. The market value balance sheet will be as follows:
Assets Liabilities +Eq Cash 2,000 Debt 6,000 Inventory 2,000 Equity 4,000 PP&E 6,000 Total Assets $10,000 Total Liab + Eq $10,000
- The risk of the asset-side of the balance sheet will remain unchanged.
- If new debt is of equal or greater priority than the original debt, then the market value of the original debt will probably decrease, because the original bondholder’s claim on the firm’s assets in the event of bankruptcy will be diluted.
- The debt-to-firm value ratio will increase: D/(D + E) = 6,000/10,000 = 0.60.
- The market value of the firm will be unchanged.
The balance sheet of the BetaMax Company is given below. Assume that all balance sheet items are expressed in market values.
Assets Liabilities+Eq Cash 2,000 Debt 5,000 Inventory 2,000 Equity 5,000 PP&E 6,000 Total Assets $10,000 Total Liab.+Eq $10,000
The company has decided to distribute $2,000 to shareholders and is considering the following two ways to distribute the money to shareholders.
A. Use the $2,000 of cash on the balance sheet to pay a dividend.
What impact will each of these 2 distribution approaches have on the following? Assume zero corporate and personal taxes.
- The risk of the asset-side of the balance sheet.
- The market value of (original) bondholders’ securities.
- The debt-to-firm value ratio (i.e., the leverage ratio).
- The market value of the firm.
A. Use the $2,000 of cash on the balance sheet to pay a dividend.
- The asset risk of the firm will increase, because a zero risk asset (cash) is no longer a part of the firm’s portfolio of assets.
- The market value of debt will probably decrease, because the risk of the firm’s portfolio of assets will increase. (Bondholders typically love to see cash on the balance sheet!)
- The leverage ratio will increase after the dividend is paid (i.e., on the ex-dividend date). The firm’s market value balance sheet will be as follows:Assets LiabilitiesCash 0 Debt 5,000
Inventory 2,000 Equity 3,000
PP&E 6,000Total Assets $8,000 Total Liabilities $8,000
Pre-dividend leverage ratio = D/(D + E) = 5,000/10,000 = 0.50
Ex-dividend leverage ratio = D/(D + E) = 5,000/8,000 = 0.625
- As seen in the market value balance sheet above, the market value of the firm will decrease by $2,000.
Assume a Company decides not to invest in a fully integrated, automated production line for new widgets. It relies instead on standard, less-expensive equipment, although the automated line is more efficient overall, according to a DCF calculation. Use real options insights to offer a brief explanation for why the firm is behaving that way.
The firm can be said to have created a put option. The standard equipment can likely be sold for more in the used equipment market than a customized, integrated system, and offers the firm the option to exit the investment at lower cost. This is not like the Enron call option discussed in class. Enron built a power plant and then mothballed it, waiting for higher electricity prices. Enron had a call option that it exercised when it activated the plant later. Here, the company does not wait to see future demand for widgets; instead it goes ahead now and produces widgets all the time, but with inefficient machines (even though the statement says that more value will be created with the standard machine despite it costing more). The explanation is that in so doing they have created (but not yet exercised) a valuable abandonment option.
TRUE / FALSE In a financially distressed firm, a project whose NPV is $200 will add less than $200 to the value of shareholders’ claims.
TRUE
[debtholders share in the NPV if debt is risky]
TRUE / FALSE An investor willing to lend at a before-tax return of 10% must be willing to lend at an after-tax return of 6.4% if her marginal income tax rate is 36%.
TRUE
TRUE / FALSE In an MM world without taxes, since the expected rate of return on debt is less than the expected rate of return on equity, the weighted average cost of capital declines as more debt is issued.
FALSE
[wacc is invariant to leverage]
TRUE / FALSE “When a company becomes bankrupt, it is usually in the interests of the equity holders to seek liquidation rather than reorganization”.
FALSE [No. Little is typically left in liquidation, lenders have priority. Also, liquidation kills the shareholders’ option to play for time in the hope of a turnaround.]
Suppose that the capital markets offered the following zero-coupon government bonds (with a $1,000 face value):
- a 1 year maturity bond selling today for a price=$900 - a 2 year maturity bond selling today for a price=$800 - a 3 year maturity bond selling today for a price=$700
Your firm is considering the following (virtually risk-free) investment project: Today: a cash outflow of $500,000 In year 1, a cash inflow of $200,000 In year 2, a cash inflow of $200,000 In year 3, a cash inflow of $200,000
Should this project be undertaken or not?
This question relies on the ‘replicating portfolio’ principle from option pricing theory, therefore the easiest answer requires no knowledge of the interest rates:
NPV=-500+200900+200800+200*700=-20 so, no, don’t do the project.
But you can also derive the 1, 2 and 3 year interest rates (11.11%, 11.8% and 12.62%) and find the NPV the normal way. Or, you can calculate the IRR of the cash flows (9.7%), which is lower than the lowest of the 3 interest rates, but caution: when the term structure is not flat, as in this example, the IRR method breaks down because there is one IRR and 3 interest rates; we cannot simply compare IRR to ‘the’ interest rate! A clever way around this is to compare 9.7% to the IRR of the sum of the cash flows of the 3 government bonds (i.e. if the cash flows are {-2400, 1000, 1000, 1000}, the IRR is 12.04%)
The Vetssatan Corporation is considering launching an improved version of its finance testing software. The investment cost is expected to be 72 million dollars and will return $13.50 million dollars in free cash flows for 5 years. No cash flows are expected after year 5. The ratio of debt to equity is one to one. The cost of equity is 15%, the cost of debt is 8%, and the tax rate is 35%. Which of the numbers below is closest to the NPV of this
-20,821,000
WACCAT=8(1-.35).5 +.515=10.1% …..ROUND TO 10%
NPV=-72+PVAF(5y, 10%)13.5=-7213.53.791=-20,821,500
In order to determine the NPV of a project undertaken by an all-equity firm, we must:
Discount the cash flows after tax by the unlevered equity rate
for an all-equity firm, the WACC boils down to the unlevered equity cost anyway
The MFC corporation needs to raise $200 million for a new project. The NPV of the project using all-equity financing is $40 million. If the transactions cost of raising funds for the project is $20 million, what is the APV of the project?
$20 million
The VSC Corporation is planning to raise $2.5 million in perpetual debt at their normal cost of debt of 11%. However, they have just received an offer from the governor of a neighboring state to raise the financing for them at an 8% interest rate if they locate themselves in that state. What is the total value added from debt financing if the tax rate is 34% and the state indeed raises the loan for the company and charges the company 8%?
$1.3 million
NPV=loan inflows – loan outflows=2.5-[(.08)(2.5)(1-.34)]/.11=2.5-1.2=1.3
TRUE / FALSE When calculating the WACCAT of a firm, one should use the book values of debt and equity.
[ use market value]
FALSE
