Problem Set
Assigned Problem 1
Poker Company has identified two methods for producing playing cards. One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards. The other method would use a less expensive machine (with fixed cost = $5,000), but it would require greater variable costs ($1.50 per deck of cards). If the selling price per deck of cards will be the same under each method, at what level of output will the two methods produce the same net operating income (EBIT)?
Assigned Problem 2
Firms HD and LD are identical except for their level of debt and the interest rates they pay on debt--HD has more debt and pays a higher interest rate on that debt. Based on the data given below, what is the difference between the two firms' ROEs?
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Applicable to Both Firms
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Firm HD's Data
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Firm LD's Data
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Assets
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$200
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Debt ratio
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50%
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Debt ratio
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30%
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EBIT
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$40
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Interest rate
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12%
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Interest rate
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10%
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Tax rate
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35%
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Assigned Problem 3
A consultant has collected the following information regarding Young Publishing:
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Total assets
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$3,000 million
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Tax rate
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40%
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Operating income (EBIT)
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$800 million
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Debt ratio
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0%
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Interest expense
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$0 million
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WACC
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10%
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Net income
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$480 million
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M/B ratio
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1.00´
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Share price
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$32.00
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EPS = DPS
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$3.20
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The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based on market values) that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 10%. If the company makes this change, what would be the total market value (in millions) of the firm?
Assigned Problem 4
Vital Factory, Inc. (VF) currently has zero debt. It is a zero growth company, and it has the data shown below. Now the company is considering using some debt, moving to the market value capital structure indicated below. The money raised would be used to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to raise somewhat, as indicated below.
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EBIT
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$80,000
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New Debt/Value
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20%
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Growth
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0%
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New Equity/Value
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80%
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Original cost of equity
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10.0%
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Number of shares
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10,000
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New cost of equity
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11.0%
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Price per share
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$48.00
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Tax rate
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40%
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Interest rate
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7.0%
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Question 1 If this plan were carried out, what would be VF's new WACC and its new value of operations?
Question 2 Now, assume that VF is considering changing from its original zero debt capital structure to a new capital structure with even more debt. This recapitalization results in changes in the cost of debt and equity, and thus to a new WACC and a new value of operations. Assume VF raises the amount of new debt indicated below and uses the funds to purchase and hold T-bills until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase?
Question 3 Based on the data in the previous two questions, what would the stock price be if VF issued the new debt and immediately used the proceeds to repurchase stock?