1. The government has agreed to lend $10 million to a firm for four years at a fixed annual rate of 4% for a project. The market rate of interest on a similar loan is 13%.
The principal is to be repaid at the end of four years. The project will require an investment of $15 million, of which $5 million will be supplied from the firm’s
internally generated funds. The free cash flows from the project are expected to be $5 million per year for each of the next four years. (a) If the firm’s corporate tax
rate is 30% and the unlevered cost of equity is 17%, what is the unlevered NPV of the project? (b) How much is the subsidized loan worth? What is the project’s NPV?
How would the NPV change if therewereno subsidizedloan?
2. XYZ Corpora on is considering an investment which costs $100 today and produces free cashflows of $72 at the end of each of the next two years. The firm faces a
corporate tax rate of 40%.Its cost of levered equity is 26%, and it can borrow at an interest rate of 10%. XYZ has a target debt-equity ra o of 1.(a) Use the weighted
average cost of capital method to determine the net present value of this investment.(b) Show how you can obtain the same answer as in part (a) by using the
adjusted present value method. (c) Show how you can obtain the same answer as in part (a) by using the flow to equitymethod.
4. Brisley Bricks Corp. is an all-equity financed firm with 3 million common shares
outstanding. The shares are currently worth $10 each. The firm wants to raise $5 million
through a rights offering. The subscrip on price has been set at $5. Determine (a) how
many rights will be needed to buy one new share; (b) the value of a right; (c) the ex-rights
share price; and (d) the total value of the firm a er the rights offering.
5.McNally Inc. is seeking to raise an addi onal $10 million through a rights offering with a
subscrip on price of $10 per share. It has correctly concluded that, as a result of the
rights offering, the firm’s share price will fall from $17.50 (rights-on) to $15 (ex-rights).
If the rights offering goes ahead, what will be the new total market value of the firm’s
equity?
3. MM Company has 2 million shares outstanding. Earnings will be $20 million at the end of year 1
and $24 million at the end of year 2. An investment outlay of $10 million at the end of year 1 has
already been decided upon. MM is all-equity with a required rate of return of 20%. The firm will
be liquidated a er 2 years. Assume that there are no taxes or transac ons costs. The firm’s policy
is to pay out any surplus cash as dividends.
(a) What is the value of MM Company today? What is its current share price?
(b) Suppose that you own 25% of MM Company and that you desire an income of $3.5
million from the firm at the end of year 1. Show how you can achieve this through
changing the current dividend policy of the firm. What is the new share price at the end
of year 1 a er the new dividend has been paid? How many new shares must MM issue in
order to switch to your desired policy? If the firm does follow this new policy, what
percentage of the firm will you own?
(c) How can you achieve the same income as in part (b) without changing the firm’s
dividend policy? What percentage of the firm will you own a er doing this?
UtopiaWorld Inc. is considering an investment which is forecasted to increase the firm’s free cashflows by $1,100 at the end of year 1, to increase its free cash flows by $1,452 at the end of
year 2, and 0 therea er. A price of $1,500 today has been nego ated for the investment. UtopiaWorld Inc. has an unlevered cost of capital of 10%, and faces a corporate tax rate of 40%.
Assume the investment has the same risk as the firm. Assume the only market imperfec on is corporate taxes.
c. (4 marks) For this part, assume UtopiaWorld Inc. will maintain a target debt to value ra o, its
equity cost of capital is 12%, and its (pre-tax) debt cost of capital is 8%. Under this leverage
policy, the project’s debt capacity is expected to be $1,125 today, $670 at the end of year 1, and 0
a erwards.
(c1) (3 marks) What is the FCFE0 today, the FCFE1 at the end of year 1, and the FCFE2 at the
end of year 2?
(c2) (1 mark) What is the present value of free cash flows to equity based on the FTE approach?