Problem 1) You and your friends have decided to examine the potential of starting a series of restaurants in and around college campuses in Boston that cater exclusively to students. Assume that (together) you have $120,000 (equity) for this project which requires an initial investment of $200,000. The remaining amount of $ 80,000 can be raised through issuing bonds. You are given the following additional information about the project.
Year Cash Flow
1 $20,000
2 $40,000
3 $60,000
4 $80,000
5 $100,000
Other Information:
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Beta based on similar businesses
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2.00
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Risk Free Rate
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4.50% / year
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Market Risk Premium
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8.00% / year
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Price per Bond
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$ 1,050
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Face Value of Bonds
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$ 1,000
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Coupon Rate on Bonds
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8.50 %
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Coupons Paid
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Monthly
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Maturity of Bonds
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5 years
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Tax rate for firm
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30%
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Will you accept or reject this project? Why?
Problem 2) You have been provided with three years of historical data for Tandem computers, a firm that has paid dividends.
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1996
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1997
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1998
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Net Income
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$150
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$225
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$315
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Capital Expenditures
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$200
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$250
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$300
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Depreciation
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$125
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$190
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$250
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Non-Cash Working Capital
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$300
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$330
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$375
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The firm started 1996 with a cash balance of $100 million, and raised 10% of its external financing needs from debt. The non-cash working capital in 1995 was $275 million. Each year the company pays out 20% of its net income as dividends.
Assuming that the firm did not buy back any stock over the period, estimate how much cash the firm would have at the end of 1998. (Assume that cash balances earn no interest and that the firm will continue to raise 10% of its external financing needs from debt)
Problem 3) You have been asked to estimate the value of General Communications, a telecomm firm. General Communications has a debt to capital ratio of 30%, a beta of 1.10 and a pre-tax cost of debt of 7.5%. The firm had earnings before interest and taxes of $ 600 million in 1998, after depreciation charges of $ 300 million. The firm had capital expenditures of $ 370 million, and non-cash working capital increased by $ 50 million during 1998. The firm also had a book value of capital of $ 2 billion at the beginning of 1998. (The treasury bond rate is 5%, the market risk premium is 6.3% and the firm has a tax rate of 40%). Assuming that the firm is in stable growth, and that the return on capital and reinvestment rates from 1998 can be sustained forever, estimate the value of the firm.
Problem 4) Teardrop, Inc., wishes to expand its facilities. The company currently has 8 million shares outstanding and no debt. The stock sells for $65 per share, but the book value per share is $20. Net Income for Teardrop is currently $11.5 million. The new facility will cost $40 million, and it will increase net income by $600,000.
a) Assuming a constant price-earnings ratio, what will be the effect of issuing new equity to finance the investment? To answer this, calculate the book value per share, the new total earnings, the new EPS, the new stock price, and the new market-to-book ratio. What is going on here? (explain in 2-3 sentences).
b) What would the new net income for Teardrop have to be for the stock price to remain unchanged?