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Chapter 17: Dynamic Capital Structures and Corporate Valuation
POINTS:
1
31. Alpha Manufacturing has the following financial information for the current year and projected for next year.
Calculate its projected free cash flow to equity.
Current
year
Projected
EBIT
1,500
1,800
Operating assets
3,000
3,400
Operating liabilities
200
220
Total debt
1,500
1,800
Interest rate on debt
6%
6%
Tax rate
25%
25%
a.
$893
b.
$983
c.
$1,081
d.
$1,189
e.
$1,308
ANSWER:
d
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Page 20
32. Eta Edibles had free cash flow to equity, required return, and long-term growth rate as indicated below. Eta has no
non-operating assets. Calculate Eta's intrinsic value of equity using the FCFE model.
Most recent FCFE
1000
Chapter 17: Dynamic Capital Structures and Corporate Valuation
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Page 21
Required return on
equity
9%
Long-term growth rate
4%
a.
$18,909
b.
$20,800
c.
$22,880
d.
$25,168
e.
$27,685
ANSWER:
b
:
33. Epsilon Consultants has the following projected free cash flows to equity and other information. It has no non-
operating assets. Calculate Epsilon's intrinsic value of equity using the FCFE model.
Year 1
Year 2
Year 3
FCFE
1,000
1,200
1,260
Long-term FCFE growth
5%
Required return on
equity
9%
a.
$28,440
Chapter 17: Dynamic Capital Structures and Corporate Valuation
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Page 22
b.
$31,284
c.
$34,413
d.
$37,854
e.
$41,640
ANSWER:
a
34. Zeta Technologies has the following projections. It has no non-operating assets. Calculate Zeta's intrinsic value of
equity using the FCFE model.
Current
year
Year 1
Year 1
Year 3
FCF
NA
1,000
1,200
1,248
Chapter 17: Dynamic Capital Structures and Corporate Valuation
Total debt
3,000
3,900
4,290
4,462
Interest rate on debt
6%
6%
6%
6%
Tax rate
25%
25%
25%
25%
Long-term growth rate
4%
Required return on
equity
9%
a.
$21,165
b.
$23,282
c.
$25,610
d.
$28,171
e.
$30,988
ANSWER:
b
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Page 24
35. Theta Therapeutics has the following information and projections. Use the FCFE model to calculate the intrinsic value
of Theta's equity.
Current
year
Year 1
Year 2
Year 3
EBIT (operating profit)
NA
1,000
1,100
1,200
Operating assets
1,200
1,300
1,500
1,600
Operating liabilities
300
300
400
500
Total Debt
1,000
900
1,100
1,200
Tax rate
NA
25%
25%
25%
Interest rate on debt
NA
6%
6%
6%
long-term growth rate
4%
Required return on equity
9%
a.
$14,156
b.
$15,572
c.
$17,129
d.
$18,842
e.
$20,726
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POINTS:
1
36. Suppose a company issued 30-year bonds 4 years ago, when the yield curve was inverted. Since then long-term rates
(10 years or longer) have remained constant, but the yield curve has resumed its normal upward slope. Under such
conditions, a bond refunding would almost certainly be profitable.
a.
True
b.
False
ANSWER:
False
37. The appropriate discount rate to use when analyzing a refunding decision is the after-tax cost of new debt, in part
because there is relatively little risk of not realizing the interest savings.
a.
True
b.
False
Chapter 17: Dynamic Capital Structures and Corporate Valuation
ANSWER:
True
38. If the firm uses the after-tax cost of new debt as the discount rate when analyzing a refunding decision, and if the NPV
of refunding is positive, then the value of the firm will be maximized if it immediately calls the outstanding debt and
replaces it with an issue that has a lower coupon rate.
a.
True
b.
False
ANSWER:
False
39. When a firm refunds a debt issue, the firm's stockholders gain and its bondholders lose. This points out the risk of a
call provision to bondholders and explains why a non-callable bond will typically command a higher price than an
otherwise similar callable bond.
a.
True
b.
False
ANSWER:
True
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40. Which of the following factors would increase the likelihood that a company would call its outstanding bonds at this
time?
a.
A provision in the bond indenture lowers the call price on specific dates, and yesterday was one of those dates.
b.
The flotation costs associated with issuing new bonds rise.
c.
The firm's CFO believes that interest rates are likely to decline in the future.
d.
The firm's CFO believes that corporate tax rates are likely to be increased in the future.
e.
The yield to maturity on the company's outstanding bonds increases due to a weakening of the firm's financial
situation.
ANSWER:
a
41. 10 years ago, the City of Melrose issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-exempt muni
bonds. The bonds had 10 years of call protection, but now the bonds can be called if the city chooses to do so. The call
premium would be 6% of the face amount. New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation
costs on this issue would be 2% of the amount of bonds sold. What is the net present value of the refunding? Note that
cities pay no income taxes, hence taxes are not relevant.
a.
$453,443
b.
$476,115
c.
$499,921
d.
$524,917
Chapter 17: Dynamic Capital Structures and Corporate Valuation
e.
$551,163
ANSWER:
a
42. Five years ago, the State of Oklahoma issued $2,000,000 of 7% coupon, 20-year semiannual payment, tax-exempt
bonds. The bonds had 5 years of call protection, but now the state can call the bonds if it chooses to do so. The call
premium would be 5% of the face amount. Today 15-year, 5%, semiannual payment bonds can be sold at par, but
flotation costs on this issue would be 2%. What is the net present value of the refunding? Because these are tax-exempt
bonds, taxes are not relevant.
a.
$278,606
b.
$292,536
c.
$307,163
d.
$322,521
e.
$338,647
ANSWER:
a
43. Which of the following statements is most CORRECT?
a.
The key benefits associated with refunding debt are the reduction in the firm's debt ratio and the creation of
more reserve borrowing capacity.
b.
The mechanics of finding the NPV of a refunding decision are fairly straightforward. However, the decision of
when to refund is not always clear because it requires a forecast of future interest rates.
c.
If a firm with a positive NPV refunding project delays refunding and interest rates rise, the firm can still obtain
the entire NPV by locking in a low coupon rate when the rates are low, even though it actually refunds the
debt after rates have risen.
d.
Suppose a firm is considering refunding and interest rates rise during time when the analysis is being done.
The rise in rates would tend to lower the expected price of the new bonds, which would make them cheaper to
the firm and thus increase the expected interest savings.
e.
If new debt is used to refund old debt, the correct discount rate to use in the refunding analysis is the before-
tax cost of new debt.
ANSWER:
b
44. Palmer Company has $5,000,000 of 15-year maturity bonds outstanding. Each bond has a maturity value of $1,000, an
annual coupon of 12.0%. The bonds can be called at any time with a premium of $50 per bond. If the bonds are called, the
company must pay flotation costs of $10 per new refunding bond. Ignore tax considerations⎯assume that the firm's tax
rate is zero.
The company's decision of whether to call the bonds depends critically on the current interest rate on newly issued bonds.
What is the breakeven interest rate, the rate below which it would be profitable to call in the bonds?
a.
9.57%
b.
10.07%
c.
10.60%
d.
11.16%
e.
11.72%
POINTS:
1
45. Stanovich Enterprises has 10-year, 12.0% semiannual coupon bonds outstanding. Each bond is now eligible to be
called at a call price of $1,060. If the bonds are called, the company must replace them with new 10-year bonds. The
flotation cost of issuing new bonds is estimated to be $45 per bond. How low would the yield to maturity on the new
bonds have to be in order for it to be profitable to call the bonds today, i.e., what is the nominal annual "breakeven rate"?
a.
9.29%
b.
9.78%
c.
10.29%
d.
10.81%
e.
11.35%
POINTS:
1
Chapter 17: Dynamic Capital Structures and Corporate Valuation
NorthWest Water (NWW)
Five years ago, NorthWest Water (NWW) issued $50,000,000 face value of 30-year bonds carrying a 14% (annual
payment) coupon. NWW is now considering refunding these bonds. It has been amortizing $3 million of flotation costs on
these bonds over their 30-year life. The company could sell a new issue of 25-year bonds at an annual interest rate of
11.67% in today's market. A call premium of 14% would be required to retire the old bonds, and flotation costs on the
new issue would amount to $3 million. NWW's marginal tax rate is 40%. The new bonds would be issued when the old
bonds are called.
46. Refer to the data for NorthWest Water (NWW). What is the required after-tax refunding investment outlay, i.e., the
cash outlay at the time of the refunding?
a.
$5,049,939
b.
$5,315,725
c.
$5,595,500
d.
$5,890,000
e.
$6,200,000
POINTS:
1
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Page 33
47. Refer to the data for NorthWest Water (NWW). What will the after-tax annual interest savings for NWW be if the
refunding takes place?
a.
$664,050
b.
$699,000
c.
$768,900
d.
$845,790
e.
$930,369
ANSWER:
b
48. Refer to the data for NorthWest Water (NWW). The amortization of flotation costs reduces taxes and thus provides an
annual cash flow. What will the net increase or decrease in the annual flotation cost tax savings be if refunding takes
place?
a.
$6,480
b.
$7,200
Chapter 17: Dynamic Capital Structures and Corporate Valuation
c.
$8,000
d.
$8,800
e.
$9,680
ANSWER:
c
49. Refer to the data for NorthWest Water (NWW). What is the NPV if NWW refunds its bonds today?
a.
$1,746,987
b.
$1,838,933
c.
$1,935,719
d.
$2,037,599
e.
$2,241,359
ANSWER:
d
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50. Holland Auto Parts is considering a merger with Workman Car Parts. Workman's market-determined beta is 0.9, and
the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Holland acquires
Workman, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free
rate is 6% and the market risk premium is 4%. Using the Compressed APV Model, what will Workman's required rate of
return on equity be after it is acquired?
a.
7.4%
b.
8.9%
c.
9.3%
d.
9.6%
e.
9.7%
ANSWER:
e
