02 Jan c. Given these price? reaction

Q 1

Gladstone Corporation is about to launch a new product. Depending on the success of the new? product, Gladstone may have one of four values next? year: $ 153$153 ?million, $ 136$136 ?million, $ 92$92 ?million, and $ 75$75 million. These outcomes are all equally? likely, and this risk is diversifiable. Gladstone will not make any payouts to investors during the year. Suppose the? risk-free interest rate is 5 %5% and assume perfect capital markets.

a. What is the initial value of? Gladstone’s equity without? leverage?

Now suppose Gladstone has? zero-coupon debt with a $ 100$100 million face value due next year.

b. What is the initial value of? Gladstone’s debt?

c. What is the? yield-to-maturity of the? debt? What is its expected? return?

d. What is the initial value of? Gladstone’s equity? What is? Gladstone’s total value with? leverage?

Q 2

Suppose Tefco Corp. has a value of $ 133$133 million if it continues to? operate, but has outstanding debt of $ 135$135 million that is now due. If the firm declares? bankruptcy, bankruptcy costs will equal $ 26$26 ?million, and the remaining $ 107$107 million will go to creditors. Instead of declaring? bankruptcy, management proposes to exchange the? firm’s debt for a fraction of its equity in a workout. What is the minimum fraction of the? firm’s equity that management would need to offer to creditors for the workout to be? successful?

Q 3

Kohwe Corporation plans to issue equity to raise $ 45$45 million to finance a new investment. After making the? investment, Kohwe expects to earn free cash flows of $ 11$11 million each year. Kohwe currently has 5 million shares? outstanding, and has no other assets or opportunities. Suppose the appropriate discount rate for? Kohwe’s future free cash flows is 6 %6%?, and the only capital market imperfections are corporate taxes and financial distress costs.

a. What is the NPV of? Kohwe’s investment?

b. What is? Kohwe’s share price? today?

Suppose Kohwe borrows the $ 45$45 million instead. The firm will pay interest only on this loan each? year, and maintain an outstanding balance of $ 45$45 million on the loan. Suppose that? Kohwe’s corporate tax rate is 30 %30%?, and expected free cash flows are still $ 11$11 million each year.

c. What is? Kohwe’s share price today if the investment is financed with? debt?

Now suppose that with? leverage, Kohwe’s expected free cash flows will decline to $ 10$10 million per year due to reduced sales and other financial distress costs. Assume that the appropriate discount rate for? Kohwe’s future free cash flows is still 6 %6%.

d. What is? Kohwe’s share price today given the financial distress costs of? leverage?

Q 4

Marpor Industries has no debt and expects to generate free cash flows of $ 15$15 million each year. Marpor believes that if it permanently increases its level of debt to $ 30$30 ?million, the risk of financial distress may cause it to lose some customers and receive less favorable terms from its suppliers. As a? result, Marpor’s expected free cash flows with debt will be only $ 14$14 million per year. Suppose? Marpor’s tax rate is 40 %40%?, the risk free rate is 6 %6%?, the expected return of the market is 14 %?, and the beta of? Marpor’s free cash flows is 1.31.3 ?(with or without? leverage).

a. Estimate? Marpor’s value without leverage.

b. Estimate? Marpor’s value with the new leverage.

Q 5

Zymase is a biotechnology startup firm. Researchers at Zymase must choose one of three different research strategies. The payoffs? (after-tax) and their likelihood for each strategy are shown below. The risk of each project is diversifiable.

Strategy

Probability

Payoff

?($ million)

A

?100%

9090

B

?50%

160160

?50%

0

C

?10%

370370

?90%

2020

a. Which project has the highest expected? payoff?

b. Suppose Zymase has debt of $ 30$30 million due at the time of the? project’s payoff. Which project has the highest expected payoff for equity? holders?

c. Suppose Zymase has debt of $ 120$120 million due at the time of the? project’s payoff. Which project has the highest expected payoff for equity? holders?

d. If management chooses the strategy that maximizes the payoff to equity? holders, what is the expected agency cost to the firm from having $ 30$30 million in debt? due? What is the expected agency cost to the firm from having $ 120$120 million in debt? due?

a. Which project has the highest expected? payoff?

The project with the highest expected payoff? is:???(Select the best choice? below.)

A.

Project A

Your answer is correct.B.

Project B

C.

Project C

b. Suppose Zymase has debt of $ 30$30 million due at the time of the? project’s payoff. Which project has the highest expected payoff for equity? holders?

If Zymase has debt of $ 30$30 million due at the time of the? project’s payoff, the project with the highest expected payoff for equity holders? is:???(Select the best choice? below.)

Q 6

RFC Corp. has announced a $ 0.82$0.82 dividend. If? RFC’s price last price? cum-dividend is $ 8.24$8.24?, what should its first? ex-dividend price be? (assuming perfect capital? markets)?

Q 7

EJH Company has a market capitalization of $ 2.7$2.7 billion and 5050 million shares outstanding. It plans to distribute $ 95$95 million through an open market repurchase. Assuming perfect capital? markets:

a. What will the price per share of EJH be right before the? repurchase?

b. How many shares will be? repurchased?

c. What will the price per share of EJH be right after the? repurchase?

Q 8

The HNH Corporation will pay a constant dividend of $ 2$2 per? share, per? year, in perpetuity. Assume all investors pay a 25 %25% tax on dividends and that there is no capital gains tax. Suppose the other investments with equivalent risk to HNH stock offer an? after-tax return of 12 %.

a. What is the price of a share of HNH? stock?

b. Assume that management makes a surprise announcement that HNH will no longer pay dividends but will use the cash to repurchase stock instead. What is the price of a share of HNH stock? now?

Q 9

Assume capital markets are perfect. Kay Industries currently has $ 125$125 million invested in? short-term Treasury securities paying 6 % comma6%, and it pays out the interest payments on these securities each year as a dividend. The board is considering selling the Treasury securities and paying out the proceeds as a? one-time dividend payment. Assume that Kay must pay a corporate tax rate of 40 %40%?, and investors pay no taxes.

a. If the board went ahead with this? plan, what would happen to the value of Kay Industries upon the announcement of a change in? policy?

b. What would happen to the value of Kay Industries on the? ex-dividend date of the? one-time dividend?

c. Given these price? reactions, will this decision benefit? investors?

Q 10

Suppose the stock of Host Hotels? & Resorts is currently trading for $ 25$25 per share.

a. If Host issued a 20 %20% stock? dividend, what will its new share price? be?

b. If Host does a 3? : 2 stock? split, what will its new share price? be?

c. If Host does a 1? : 3 reverse? split, what will its new share price? be?