Problem 1: Miscellaneous Topics
The following questions are conceptual questions on several topics. In answering the questions, be clear and to-the-point. The motivation of your answer determines the grade.
(i) Suppose you have to choose between three projects. All involve production technologies that will be repeated at the end of their economic lives. Relevant project information is summarized below. Your supervisor expects a recommendation consistent with shareholder value maximization (his compensation package is linked to the share price of the firm). Which of the projects would you recommend to him, and how can you explain the difference in project rankings between the different capital budgeting criteria? Motivate your answer (no calculations are needed).
|
Project
|
t= 0
|
t= 1
|
t= 2
|
t= 3
|
IRR
|
NPV @10%
|
EA
|
|
A
|
########
|
$250,000
|
$250,000
|
$200,000
|
19.70%
|
$84,147
|
$33,837
|
|
B
|
########
|
$500,000
|
$750,000
|
-
|
15.10%
|
$74,380
|
$42,857
|
|
C
|
########
|
$250,000
|
$750,000
|
########
|
13.10%
|
$98,422
|
$39,577
|
(ii) As part of its efforts to stimulate the economy after the crisis, the Obama administration allowed small businesses to immediately write down capital expenditures for tax purposes. The policy is now being reviewed as part of the discussion on corporate tax reform. One of your colleagues argues that this ultimate form of accelerated depreciation is always beneficial to companies. Another colleague argues that this is not necessarily true, but depends on the salvage value of the asset at the time it is sold. In particular, if a firm sells an asset at a price above book value, accelerated depreciation may be less attractive. A third colleague points out that the depreciation method used by a firm is irrelevant, since depreciation is a non-cash expense, and therefore only affects accounting earnings. Please respond to each of these statements. Who do you agree with and how would you assess the attractiveness of the Obama policy? Motivate your answer.
(iii) American Chemical, a large chemical conglomerate, is planning to buy the Paper division of Du Pont. A Stem student doing an internship at the firm has been asked to identify the correct cost of capital of American Chemical after the acquisition and collected the following firm and financial market information. The student established that all firms in the table pay corporate taxes at a 35% rate, and estimated a market risk premium of 6%. The target capital structure for the acquisition is 50% debt. American Chemical's target capital structure has 40% debt and Du Pont's Paper division has 30% debt. Describe clearly how the student should proceed in estimating the correct cost of capital. Motivate your input choices, discuss any additional information you would need and show the steps (You can include any formulas you would use, but no calculations are needed).
|
Company
|
% of Total Sales
|
Equity Beta (βE)
|
Market Debt ratio (D/V)
|
Bond Rating
|
|
Chemical
|
Paper
|
Other
|
|
American Chemical
|
100
|
0
|
0
|
1.67
|
35
|
BBB
|
|
Du Pont
|
70
|
30
|
0
|
1.47
|
27
|
AAA
|
|
Monsanto
|
80
|
0
|
20
|
1.53
|
43
|
AA
|
|
International Paper
|
0
|
85
|
15
|
1.6
|
55
|
BBB
|
|
Kimberly Clark
|
0
|
95
|
5
|
1.15
|
35
|
AA
|
|
Bond Yields
|
|
|
|
|
T-Bonds
|
5.90%
|
|
Corporate Bonds
|
|
|
AAA
|
6.30%
|
|
AA
|
6.65%
|
|
A
|
6.90%
|
|
BBB
|
7.65%
|
Problem 2: Security Valuation and the Fundamentals of Bond and Stock Prices
Suppose you are working on a bond issue for WeWork, a U.S. based firm with a BB credit rating. WeWork plans to issue 10-year par bonds with a face value of $1,000, and has not issued debt before. A competitor with a similar bond rating as WeWork issued 15-year par bonds 5 years ago with face value of $1,000 and an annual coupon rate of 6.5% (paid semi-annually). These bonds are currently trading in the market at a price of $910.88. The 15-year US Treasury bond rate 5 years ago was 2% and the yield on 10-year par US Treasury bonds today is 3%. With this information, answer the following two questions.
(i) What is the yield to maturity on the bonds that WeWork's competitor issued 5 years ago? And what would be the coupon rate at which you expect WeWork could issue the 10-year par bonds today? Clearly describe the inputs to your calculations and motivate your answer.
(ii) Explain why the corporate bonds issued by the competitor 5 years ago are trading below par. Also discuss how the risk of these bonds has changed over time. Are investors today more or less concerned about the interest rate risk and the credit risk of the competitor's bonds than they were 5 years ago? Explain your answer (no calculations are needed).
A mature U.S. telecommunications company expects to pay a dividend per share of $6 next year (paid annually at the end of the year) and expects the dividend to grow at a constant rate in the future. The firm's equity beta equals 0.65. The risk free rate is 3%, and the expected return on the stock market index is 8%. The firm reinvests 20% of its earnings at an ROE of 12.5%. The current book value per share is $60. With this information, please answer the following two questions.
(iii) Determine the required return on the stock based on CAPM and calculate the intrinsic value per share for the telecommunications company. Also explain the difference between the market value and the book value per share. Motivate your answer and show your calculations.
(iv) Suppose the firm wants to grow at a higher rate of 7.5% in the future. If the firm keeps its ROE at 12.5%, what would be the impact of this strategy on the dividend in the short run and the value per share? And what would be the impact on the dividends and the value per share if the firm expects to increase its ROE to 15%? Explain your answer (no calculations are needed).
Problem 3: Investment Analysis and Project Evaluation
CDS, a pharmacy chain, is considering a 5-year trial to establish an in-store clinic in one if its US locations. Customers in this location could receive non-emergency and preventative medical care at a lower cost. If the in-store clinic concept is successful, it could be replicated throughout the US. The company has hired a consultant who has collected the following information:
- The trial requires an immediate investment of $800,000 in medical equipment and store infrastructure. The investment will have a 8-year economic life and will be depreciated straight-line to a salvage value of zero. After 5 years, the equipment can be sold for $400,000.
- Since the trial is part of the health care reform agenda aimed at reducing overall health care costs, CDS can immediately claim a tax credit of $50,000 if it undertakes the trial.
- The in-store clinic's revenues are $450,000 per year (starting in year 1) and its operating cash costs (staff salaries, medical supplies, etc.) are expected to be $250,000 per year.
- The in-store clinic will require a level of Net Working Capital equal to 10% of the revenues in the following year. The working capital needs to built up immediately.
- The consultant's fee equals $25,000 and has not yet been paid
The consultant has estimated that the relevant discount rate for an investment of this type equals 15%. The marginal corporate tax rate for CDS is 40%. Furthermore, you can assume that all cash flows will be realized at the end of each year. With this information please answer the following two questions.
(i) Should CDS undertake the trial and establish the in-store clinic? Motivate your approach and show all your calculations.
(ii) Now suppose that the consultant determined that if CDS does not establish the in-store clinic, the firm would lose $1,000,000 in pharmacy sales in each year of the trial if a competitor decides to open a clinic. If we assume that the probability of competitive entry equals 50%, the pharmacy's operating profit (EBIT) margin equals 20% of pharmacy sales and the immediate investment in working capital needed to support pharmacy sales equals 30% of the sales in the following year, how does would this information affect the value of the trial clinic to CDS and the firm's decision to invest? Clearly describe your approach and show all your calculations.
Problem 4: Capital Structure, Payout Policy and Cost of Capital
Pharma-C is a pharmaceutical firm that manufactures and sells a portfolio of blockbuster drugs at high margins. The firm is all-equity financed and has 40 million shares outstanding at a price of $75 per share. Pharma-C's current cost of capital is 7.5%. The firm is considering to buy back $400 million in shares in the open market and to finance the repurchase by issuing bonds. Pharma-C plans to maintain this capital structure indefinitely. At this level of debt, the bonds would be A-rated, and the firm would pay an interest rate of 4.5%. Pharma C's- marginal corporate tax rate is 25%. With this information answer the following three questions.
(i) Calculate the stock price of Pharma-C when the share repurchase plan is announced to the market, and also determine how many shares the firm would need to repurchase. Clearly describe your approach.
(ii) Determine Pharma-C's cost of equity and its cost of capital after the share repurchase and explain the directional change for both.
(iii) Now suppose that the stock price upon announcement of the share repurchase plan equals $77.90. If we assume that the market is efficient, and the firm has not released any other information, what can you infer from this regarding the market's assessment of Pharma-C's cost of financial distress, and how would you estimate these costs? Motivate your approach and discuss the inputs in any calculations.
Problem 5: Cash Flows and Cost of Capital for In-Charge
In-Charge is a publicly listed firm that provides technology allowing customers to monitor their credit and debit card use, set spending limits and activate and de-activate cards through apps on mobile devices. The company recently struck deals with key payment processing companies to adopt this technology in order to prevent fraud. In-Charge is entering a fast growth phase, which is expected to last for 5 years. The following table contains reported income statement information for the recent year 2018 (all numbers are in $1,000s):
|
Year
|
2018
|
|
Revenues
|
4,500
|
|
Operating Costs (incl. Depreciation.)
|
2,250
|
|
EBIT
|
2,250
|
|
Interest expense
|
2,025
|
|
EBT
|
225
|
|
Taxes
|
90
|
|
Net Income
|
135
|
Detailed projections (in $1,000s) for the years 2019-2023 are given below:
- Expected growth in revenues is 100% per year.
- Operating profit (EBIT) equals 50% of revenues in each of the years 2019-2023.
- The increase in net working capital equals 25% of revenues in each of the years 2019-2023.
- Gross investments in fixed assets equal $1,200 in each of the years 2019-2023.
- The amount of depreciation is equal to $700 in each of the years 2019-2023.
In-Charge currently has 2 million shares outstanding and has a debt ratio (DI V) of 50% in market value terms. The firm has a BBB bond rating and its equity beta equals 1.90. The interest rate on T-bonds equals 2.5%, the expected yield on BBB-rated bonds is 4% and the market risk premium is 5%. Finally, you can assume that all cash flows will be realized at the end of the year and that the firm is subject to a 40% marginal corporate tax rate. With this information answer the following four questions.
(i) Determine the relevant Free Cash Flows for a valuation of the firm for the years 2019-2023 (in $1,000s). Show your calculations.
(ii) Calculate the weighted average cost of capital for In-Charge. Show all your calculations.
(iii) Determine In-Charge's business risk (or asset beta). Show all your calculations.
(iv) Now suppose that In-Charge wants to immediately change its leverage to 25% with a corresponding cost of debt of 3%. If we assume that In-Charge maintains a constant growth rate of 2% after 2023, what is In-Charge's share price?
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