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Exam 21: Dynamic Capital Structures and Corporate Valuation

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Question 1

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Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT?

A) The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt.
B) The horizon value is calculated by discounting the expected earnings at the WACC.
C) The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC.
D) The horizon value must always be more than 20 years in the future.
E) The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity.

F) C) and E)
G) A) and C)

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Question 2

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Sallie's Sandwiches Sallie's Sandwiches is financed using 20% debt at a cost of 8%.Sallie projects combined free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4.(The Year 4 value includes the combined horizon values of FCF and tax shields.) All cash flows are expected to grow at a 3% constant rate after Year 4.Sallie's beta is 2.0, and its tax rate is 25%.The risk-free rate is 6%, and the market risk premium is 5%. -Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the total value (in millions) ?

A) $72.37
B) $73.99
C) $74.49
D) $75.81
E) $76.45

F) A) and E)
G) D) and E)

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Question 3

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The rate used to discount projected merger cash flows should be the cost of capital of the new consolidated firm because it incorporates the actual capital structure of the new firm.

Volunteer Enterprises has the following information for the current year.Calculate its free cash flow to equity. $\begin{array} { l r } \text { FCF } & \$ 1,000 \\\text { Interest expense } & \$ 40 \\\text { Frincipal payments } & \$ 200 \\\text { New debt } & \$ 300 \\\text { Tax rate } & 25 \%\end{array}$ ?

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

Kitto Electronics Data Kitto Electronics expects an EBIT of $200,000 for Year-1.EBIT is expected to grow at 6% thereafter.The tax rate is 25%.In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets.Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%. -Refer to data for Kitto Electronics.Using the compressed adjusted present value model, what is the value of Kitto's tax shield?

In a world with no taxes, MM show that a firm's capital structure does not affect the firm's value.However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

Glassmaker Corporation Data Glassmaker Corporation has a currentcapital structure consisting of $100 million (market value) of 9% bonds and $300 million (market value) of common stock.Glassmaker's beta is 1.5.Glassmaker faces a 25% tax rate.Glassmaker plans on making big changes in operation and capital structure during the next several years.(Its tax rate will remain unchanged.) Under these plans, the free cash flows for Glassmaker are estimated to be $29 million for each of the next 4 years; the horizon value of the free cash flows (discounted at the rate assumed by the compressed adjusted present value (CAPV) approach) is $487 million at Year 4.Glass maker will increase its debt to $140 million in the recapitalization.This will cause the estimatedtax savings due to interest expenses areestimatedto be$3.2 million for each of the next 4 years; the horizon value of the tax shields (discounted at the rate assumed by the CAPV approach) is estimated to be $53 million at Year 4.Glassmaker has no nonoperating assets.Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%. ​ -Refer to data for Glassmaker Corporation.Using the compressed adjusted present value model, how much will Glassmaker's equity be worth after completing the recapitalization? (Round your answer to the closest thousand dollars.)

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

Alpha Manufacturing has the following financial information for the current year and projected for next year.Calculate its projected free cash flow to equity. $\begin{array} { l r r } &\text { Current } \\& { \text { year } } & \text { Projected } \\\text { EBIT } & \$ 1,500 & \$ 1,800 \\\text { Operating assets } & \$ 3,000 & \$ 3,400 \\\text { Operating liabilities } & \$ 200 & \$ 220 \\\text { Total debt } & \$ 1,500 & \$ 1,800 \\\text { Interest rate on debt } & 6 \% & 6 \% \\\text { Tax rate } & 25 \% & 25 \%\end{array}$

Sallie's Sandwiches Sallie's Sandwiches is financed using 20% debt at a cost of 8%.Sallie projects combined free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4.(The Year 4 value includes the combined horizon values of FCF and tax shields.) All cash flows are expected to grow at a 3% constant rate after Year 4.Sallie's beta is 2.0, and its tax rate is 25%.The risk-free rate is 6%, and the market risk premium is 5%. -Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the appropriate rate for use in discounting the free cash flows and the interest tax savings?

Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT?

MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt.

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the unlevered cost of equity.

Theta Therapeutics has the following information and projections.Use the FCFE model to calculate the intrinsic value of Theta's equity. $\begin{array} { l r r r r } &{ \text { Current } } & & \\ & \text { year } & \text { Year 1 } & \text { Year 2 } & \text { Year 3 } \\\text { EBIT (operating profit) } & \text { NA } & \$ 1,000 & \$ 1,100 & \$ 1,200 \\\text { Operating assets } & \$ 1,200 & \$ 1,300 & \$ 1,500 & \$ 1,600 \\\text { Operating liabilities }& \$ 300 & \$ 300 & \$ 400 & \$ 500 \\\text { Total Debt } & \$ 1,000 & \$ 900 & \$ 1,100 & \$ 1,200 \\\text { Tax rate } & \mathrm { NA } & 25 \% & 25 \% & 25 \% \\\text { Interest rate on debt } & \mathrm { NA } & 6 \% & 6 \% & 6 \% \\\text { long-term growth rate } & 4 \% & & &\\\text { Required return on equity }&9\%\end{array}$

Kitto Electronics Data Kitto Electronics expects an EBIT of $200,000 for Year-1.EBIT is expected to grow at 6% thereafter.The tax rate is 25%.In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets.Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%. -Refer to data for Kitto Electronics.According to the compressed adjusted present value model, what is Kitto's unlevered value?

According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the WACC.

Glassmaker Corporation Data Glassmaker Corporation has a currentcapital structure consisting of $100 million (market value) of 9% bonds and $300 million (market value) of common stock.Glassmaker's beta is 1.5.Glassmaker faces a 25% tax rate.Glassmaker plans on making big changes in operation and capital structure during the next several years.(Its tax rate will remain unchanged.) Under these plans, the free cash flows for Glassmaker are estimated to be $29 million for each of the next 4 years; the horizon value of the free cash flows (discounted at the rate assumed by the compressed adjusted present value (CAPV) approach) is $487 million at Year 4.Glass maker will increase its debt to $140 million in the recapitalization.This will cause the estimatedtax savings due to interest expenses areestimatedto be$3.2 million for each of the next 4 years; the horizon value of the tax shields (discounted at the rate assumed by the CAPV approach) is estimated to be $53 million at Year 4.Glassmaker has no nonoperating assets.Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%. ​ -Refer to data for Glassmaker Corporation.What is Glassmaker's current levered cost of equity based on its current capital structure?

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?