RSM333 - Assignment #2 – Fall 2015
Question # 00146515
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Updated on: 12/05/2015 12:38 PM Due on: 01/04/2016
RSM333 - Assignment #2 – Fall 2015
Can you help me just with questions 1, 3 and 5
You may work in groups of 3 to 4 students.
Due IN CLASS, Wednesday December 9
Question 1 (10 marks)
BigCo, a conglomerate with beta of 0.8, and debt to equity of 0.15 is thinking of launching a risky project in the mining
sector, which is significantly more risky than BigCo’s current operations. BigCo has a cost of debt capital of 6%. BigCo
notes that there is a publicly traded company called MineCo, which appears to be a good benchmark for the project that
BigCo is contemplating. MineCo has a debt to equity of 0.7, an equity beta of 1.4, and its debt yields 7.5%. Both BigCo
and MineCo face corporate tax rates of 25%. The risk free rate is 5%, the market risk premium is 6%, and the beta of both
companies’ debt is zero.
BigCo has not decided which method it will use to estimate the value of the expected future cash flows from its mining
sector project. Thus BigCo would like to calculate the unlevered cost of equity, the levered cost of equity and the after tax
weighted average cost of capital it should use to discount the future cash flows from the project, so that it may use any
of the WACC, APV, or Flow-to-Equity (CFs to equity discounted at KeL to find the market capitalization) approaches to
valuing its project.
a) Why doesn’t BigCo just use its own measures of discount rates to estimate the value of its project? (2 marks)
b) Find the unlevered cost of equity that should be used to discount the equity cash flows from the project to
estimate the all-equity value of the project. (3 marks)
c) Assuming the project uses the same capital structure as BigCo itself, find the levered cost of equity that should
be used to discount the annual net income from the project (3 marks)
d) Find the weighted average cost of capital that should be used to discount the project’s free cash flows, again
assuming it is financed like BigCo itself. (2 marks)
Question 2 (10 marks)
Consider a world with no bankruptcy costs, perfect capital markets, and in which all firms pay a 30% tax rate. Enormous
Corp. has three operating divisions: the foods, electronics, and chemicals divisions account for 50%, 30%, and 20% of
Enormous' assets value, respectively. Currently, the firm’s capital structure is 40% risk-free (zero-beta) debt. The
expected market return is 9% and the current risk-free interest rate is 3%. To help work out the divisional cost of capital,
the following three competitors (who also have risk-free debt) have been identified as having investments (business risk)
similar to those of XYZ’s three divisions:
Comparison Company
A - Food
B - Electronics
C - Chemicals
Equity Beta
0.8
1.6
1.2
WD in their capital structure
0.3
0.2
0.4
a) What is the cost of equity for each comparison firm? (3 marks)
b) What is the cost of capital for each of Enormous' divisions? (3 marks)
c) Calculate Enormous' WACC if the firm's managers decided to leverage the company by buying back stock with
new debt until debt accounts for half of its capital structure (4 marks)
Question 3 (10 marks)
RSM333 - Assignment #2 – Fall 2015
You may work in groups of 3 to 4 students.
Due IN CLASS, Wednesday December 9
The Fast Tracker Company is unlevered and currently valued in the market at $640,000 but the firm is considering
leveraging its capital structure with bank debt. In particular, the firm is considering raising enough debt with 8% interest
rate to repurchase $300,000 of common stocks. Historically, the firm's market beta has been 0.8, their national market is
expected to return 14% in the long-run, and the long-run risk-free rate is 4%. There
Can you help me just with questions 1, 3 and 5
You may work in groups of 3 to 4 students.
Due IN CLASS, Wednesday December 9
Question 1 (10 marks)
BigCo, a conglomerate with beta of 0.8, and debt to equity of 0.15 is thinking of launching a risky project in the mining
sector, which is significantly more risky than BigCo’s current operations. BigCo has a cost of debt capital of 6%. BigCo
notes that there is a publicly traded company called MineCo, which appears to be a good benchmark for the project that
BigCo is contemplating. MineCo has a debt to equity of 0.7, an equity beta of 1.4, and its debt yields 7.5%. Both BigCo
and MineCo face corporate tax rates of 25%. The risk free rate is 5%, the market risk premium is 6%, and the beta of both
companies’ debt is zero.
BigCo has not decided which method it will use to estimate the value of the expected future cash flows from its mining
sector project. Thus BigCo would like to calculate the unlevered cost of equity, the levered cost of equity and the after tax
weighted average cost of capital it should use to discount the future cash flows from the project, so that it may use any
of the WACC, APV, or Flow-to-Equity (CFs to equity discounted at KeL to find the market capitalization) approaches to
valuing its project.
a) Why doesn’t BigCo just use its own measures of discount rates to estimate the value of its project? (2 marks)
b) Find the unlevered cost of equity that should be used to discount the equity cash flows from the project to
estimate the all-equity value of the project. (3 marks)
c) Assuming the project uses the same capital structure as BigCo itself, find the levered cost of equity that should
be used to discount the annual net income from the project (3 marks)
d) Find the weighted average cost of capital that should be used to discount the project’s free cash flows, again
assuming it is financed like BigCo itself. (2 marks)
Question 2 (10 marks)
Consider a world with no bankruptcy costs, perfect capital markets, and in which all firms pay a 30% tax rate. Enormous
Corp. has three operating divisions: the foods, electronics, and chemicals divisions account for 50%, 30%, and 20% of
Enormous' assets value, respectively. Currently, the firm’s capital structure is 40% risk-free (zero-beta) debt. The
expected market return is 9% and the current risk-free interest rate is 3%. To help work out the divisional cost of capital,
the following three competitors (who also have risk-free debt) have been identified as having investments (business risk)
similar to those of XYZ’s three divisions:
Comparison Company
A - Food
B - Electronics
C - Chemicals
Equity Beta
0.8
1.6
1.2
WD in their capital structure
0.3
0.2
0.4
a) What is the cost of equity for each comparison firm? (3 marks)
b) What is the cost of capital for each of Enormous' divisions? (3 marks)
c) Calculate Enormous' WACC if the firm's managers decided to leverage the company by buying back stock with
new debt until debt accounts for half of its capital structure (4 marks)
Question 3 (10 marks)
RSM333 - Assignment #2 – Fall 2015
You may work in groups of 3 to 4 students.
Due IN CLASS, Wednesday December 9
The Fast Tracker Company is unlevered and currently valued in the market at $640,000 but the firm is considering
leveraging its capital structure with bank debt. In particular, the firm is considering raising enough debt with 8% interest
rate to repurchase $300,000 of common stocks. Historically, the firm's market beta has been 0.8, their national market is
expected to return 14% in the long-run, and the long-run risk-free rate is 4%. There
are currently 32,000 shares
outstanding and the marginal tax rate is zero.
a) What is the cost of equity for Fast Tracker before and after the debt issue? (2 marks)
b) Assume now that the whole change in capital structure will cost Fast Tracker $25,000 in floatation costs. What is
the value of the firm after the change in the capital structure? (2 marks)
c) How will your answer change to part b if the marginal tax rate is 34% for Fast Tracker? (2 marks)
d) What is the minimum marginal tax rate for Fast Tracker to be willing to issue the debt? (2 marks)
e) According to the pecking order theory of capital structure, would the company be more inclined to leverage
themselves through the use of bank debt instead of selling bonds into the public debt markets? (2 marks)
Question 4 (10 marks)
a) Give one example of a direct cost of bankruptcy and one example of an indirect cost of bankruptcy. (2 marks)
b) Falcon Security is a broad-based security contractor working with a number of government projects. In
response to problems which had resulted from "fast and loose" oversight of the industry during the past few
years, the federal government mandated a maximum profit margin of 8% after tax for the shareholders of
companies involved in this line of work. If the firm has an asset turnover of 2.1 and its shareholders require a
28% return on their equity, calculate the firm's target Debt / Equity ratio. (3 marks)
c) Using the cash flows to investors, prove that in a world with no distress costs, no taxes, and perfect capital
markets, that firm value is not affected by capital structure decisions. (5 marks)
Question 5 (10 marks)
Foxy News (currently trading at $50/share) is considering purchasing its rival Pulitzer Publications. Both firms currently
have 1,000,000 shares outstanding and Pulitzer generates $1,500,000 in free cash flows each year. Foxy estimates that
synergies between the two firms would generate another $100,000 each year in free cash flows as well as increase
growth in Pulitzer’s business from 5% to 6% each year (the appropriate discount rate for Pulitzer is 10%). Foxy’s
management is considering whether to offer straight cash for each share of Pulitzer or whether to offer their target a
40% stake in the combined firm.
a) If Pulitzer's shareholders are indifferent between a cash purchase and an equity-backed purchase, at what price
per share would the shareholders of Pulitzer be indifferent between the two offers? (4 marks)
b) Why are straight cash offers often preferred over purchases made with common stock or even combined
cash/stock offers? (2 marks)
c) Why would a hostile takeover offer be more likely to misprice a target acquisition than a friendly acquisition? (2
marks)
d) Why are the average prices of firms with shareholder rights plans (aka poison pills) generally lower than those
without such means to fend off hostile takeovers? (2 marks)
Question 6 (10 marks)
RSM333 - Assignment #2 – Fall 2015
You may work in groups of 3 to 4 students.
Due IN CLASS, Wednesday December 9
Kester Limited is an all equity firm that is considering the acquisition of Lignite Corporation. Kester's market
capitalization is $30 million and it has 600,000 shares outstanding. Lignite's market capitalization is $3.5 million. After
the merger, Kester's executives estimate that the combined company will experience an immediate, permanent increase
in annual profit of $100,000. Kester will use a 12.5% cost of capital to evaluate the proposed acquisition. Because of the
friendly nature of the merger, Kester has made two offers to the shareholders of Lignite Corporation: one for $3.95
million in cash, the other for 75,000 shares of the merged company.
a) Assuming a no-tax environment, which of the two offers are Lignite's shareholders likely to prefer? (2 marks)
b) Calculate Kester's share price assuming that each offer is accepted (report both prices) (4 marks)
c) What is the minimum level of yearly synergies Kester needs to achieve in order to justify the greater of the two
offers they have made? (2 marks)
d) Assume now that Kester also expects to incur integration costs related to the merger of $200,000. What is the
yearly minimum synergies that must be achieved in order to justify the higher bid? (2 marks)
outstanding and the marginal tax rate is zero.
a) What is the cost of equity for Fast Tracker before and after the debt issue? (2 marks)
b) Assume now that the whole change in capital structure will cost Fast Tracker $25,000 in floatation costs. What is
the value of the firm after the change in the capital structure? (2 marks)
c) How will your answer change to part b if the marginal tax rate is 34% for Fast Tracker? (2 marks)
d) What is the minimum marginal tax rate for Fast Tracker to be willing to issue the debt? (2 marks)
e) According to the pecking order theory of capital structure, would the company be more inclined to leverage
themselves through the use of bank debt instead of selling bonds into the public debt markets? (2 marks)
Question 4 (10 marks)
a) Give one example of a direct cost of bankruptcy and one example of an indirect cost of bankruptcy. (2 marks)
b) Falcon Security is a broad-based security contractor working with a number of government projects. In
response to problems which had resulted from "fast and loose" oversight of the industry during the past few
years, the federal government mandated a maximum profit margin of 8% after tax for the shareholders of
companies involved in this line of work. If the firm has an asset turnover of 2.1 and its shareholders require a
28% return on their equity, calculate the firm's target Debt / Equity ratio. (3 marks)
c) Using the cash flows to investors, prove that in a world with no distress costs, no taxes, and perfect capital
markets, that firm value is not affected by capital structure decisions. (5 marks)
Question 5 (10 marks)
Foxy News (currently trading at $50/share) is considering purchasing its rival Pulitzer Publications. Both firms currently
have 1,000,000 shares outstanding and Pulitzer generates $1,500,000 in free cash flows each year. Foxy estimates that
synergies between the two firms would generate another $100,000 each year in free cash flows as well as increase
growth in Pulitzer’s business from 5% to 6% each year (the appropriate discount rate for Pulitzer is 10%). Foxy’s
management is considering whether to offer straight cash for each share of Pulitzer or whether to offer their target a
40% stake in the combined firm.
a) If Pulitzer's shareholders are indifferent between a cash purchase and an equity-backed purchase, at what price
per share would the shareholders of Pulitzer be indifferent between the two offers? (4 marks)
b) Why are straight cash offers often preferred over purchases made with common stock or even combined
cash/stock offers? (2 marks)
c) Why would a hostile takeover offer be more likely to misprice a target acquisition than a friendly acquisition? (2
marks)
d) Why are the average prices of firms with shareholder rights plans (aka poison pills) generally lower than those
without such means to fend off hostile takeovers? (2 marks)
Question 6 (10 marks)
RSM333 - Assignment #2 – Fall 2015
You may work in groups of 3 to 4 students.
Due IN CLASS, Wednesday December 9
Kester Limited is an all equity firm that is considering the acquisition of Lignite Corporation. Kester's market
capitalization is $30 million and it has 600,000 shares outstanding. Lignite's market capitalization is $3.5 million. After
the merger, Kester's executives estimate that the combined company will experience an immediate, permanent increase
in annual profit of $100,000. Kester will use a 12.5% cost of capital to evaluate the proposed acquisition. Because of the
friendly nature of the merger, Kester has made two offers to the shareholders of Lignite Corporation: one for $3.95
million in cash, the other for 75,000 shares of the merged company.
a) Assuming a no-tax environment, which of the two offers are Lignite's shareholders likely to prefer? (2 marks)
b) Calculate Kester's share price assuming that each offer is accepted (report both prices) (4 marks)
c) What is the minimum level of yearly synergies Kester needs to achieve in order to justify the greater of the two
offers they have made? (2 marks)
d) Assume now that Kester also expects to incur integration costs related to the merger of $200,000. What is the
yearly minimum synergies that must be achieved in order to justify the higher bid? (2 marks)
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Solution: RSM333 - Assignment #2 – Fall 2015- Can you help me just with questions 1, 3 and 5