Name: ____________________________
ID: ____________________________
9.348 — Corporate Finance Theory and Practice
Assignment 4
Dr. D.A. Stangeland
Due Wednesday, April 8, 1998 at 11:30 a.m. Remember that this assignment is to be done on an individual
basis. Do not consult your peers. Any suspected breaches of the Faculty’s code of academic integrity will be
sent to the Dean’s office. Only selected parts will be marked.
1) Plutonic Inc. is considering investing in the following project:
 asset: initial cost, $10 million; CCA rate, 25%; expected salvage time and amount, 8 years, $5 million
(Assume CCA tax shields and salvage are about as risky as Plutonic’s debt and are therefore discounted at
the after-tax cost of debt.) Assume a terminating asset class when the asset is sold.
 revenues: year 1, $6 million; expected growth rate in revenues, 3%/year; last year of revenues; year 8
 expenses: 1st in 1 year 1, $2 million/year in real terms; expected inflation rate, 2%; last year of expenses;
year 8
 tax considerations:
 corporate rate, 45%
 marginal investors’ personal rate on debt income, 45%
 marginal investors’ personal rate on equity income, 15%
 Plutonic’s expected capital structure: 30% debt, 70% equity
 Plutonic’s securities’ returns: rB=8%, rS=20%
 This project’s revenues and expenses are unlike Plutonic’s other projects. Another company, Uranus Corp.,
invests primarily in projects with the same risk as this project’s revenues and expenses. The following data
has been gathered about Uranus Corp.:
 Debt to equity ratio, 1:1
 rB=7%, rS=16%
a) Determine what would be the expected return of Uranus if it were 100% equity financed (i.e., unlevered).
__________________________%
b) Determine what would be the expected return of levered equity for this project’s revenues and expenses in
Plutonic given Plutonic’s capital structure and debt.
__________________________%
c) Determine Plutonic’s risk-adjusted WACC for this project’s revenues and expenses.
__________________________%
d) Determine the NPV of the project using the risk-adjusted WACC approach. (Beware, CCA and salvage are
discounted at a different rate.)
$__________________________
e) Now use the APV method. What discount rate should be used for the project’s revenues and expenses?
__________________________%
f) What is the NPV (under the APV method)?
$__________________________
g) What is Plutonic’s target amount of debt financing for this project?
$__________________________
h) Assuming debt tax shields are the only financing side effects, what is the NPVF?
i) Calculate NPVF ignoring personal tax considerations.
$__________________________
ii) Calculate NPVF including both corporate and personal tax considerations.
$__________________________
i) What is the APV?
i) Calculate APV ignoring personal tax considerations.
$__________________________
ii) Calculate APV including both corporate and personal tax considerations.
$__________________________
j) What is your conclusion? Should the project be accepted?
__________________________
2) Scott owns 10,000 shares in Beagle Express Corp (BEC). Nicole owns 10,000 shares in Unity Parcel
Service (UPS). Both originally paid $8 per share for their stocks. Both Scott and Nicole have the same
preferences regarding the payment of dividends. Both BEC and UPS have 100 million shares outstanding
valued at $8 per share prior to the ex-dividend date. BEC’s stock has just gone ex-dividend and is about to
pay a dividend of $0.50 per share; BEC is financing the dividend with a new share issue. UPS pays no
dividend.
a) Assume there are no taxes or transaction costs. What must Scott and Nicole do if they both desire a
dividend of $0.50 per share so that they can spend the cash? Be explicit.
Who is better off? ______________
b) Assume there are no taxes or transaction costs. What must Scott and Nicole do if neither wants a
dividend? Be explicit.
Who is better off? ______________
c) Assume there are transaction costs but no taxes. What must Scott and Nicole do if neither wants a
dividend? (Explain but do not do any calculations.)
Who is better off? ______________
d) Assume there are taxes but there are no transaction costs. What must Scott and Nicole do if they both
desire a dividend of $0.50 per share so that they can spend the cash? Who is better off? (Explain but do
not do any calculations.)
Who is better off? ______________
3) Suppose the provincial government is willing to guarantee a loan for the purchase of a nickel mine. The
amount to be borrowed is $21 million. With the government loan guarantee, the cost of the loan is only 6%
(equal to the risk-free rate). The current market value of the mine is $25 million. All nickel will be mined
in one year and the net value after one year’s production will either be $19 million or $33.75 million. (The
loan plus an equity infusion finance the purchase price for the mine.)
a) Use the Binomial option-pricing model to determine the value of the loan guarantee.
$__________________________
b) Given the promised payments on this debt, how much could have been borrowed without the
government loan guarantee?
$__________________________
c) Given the promised payments on the debt and the amount you calculated in (b), what would be the
required promised return on the debt without the loan guarantee
__________________________%
d) Suppose the government guarantees the loan before the bonds are sold to investors.
i) Who receives the value of the guarantee? Explain briefly.
ii) What is the NPV or APV of the mine purchase if the mine is purchased for $25 million?
$__________________________
e) Suppose the government decided to guarantee the loan after investors purchased the bonds.
i) Who would receive the value of the guarantee? Explain briefly.
ii) What is the NPV or APV of the mine purchase if the mine is purchased for $25 million?
$__________________________
f) Indicate what will be the possible values of the equity after one year.