You have the following information about two firms, Debt Free, Inc

Round your answers to two decimal points, and do not round intermediate calculations.

Problem 1.

You have the following information about two firms, Debt Free, Inc. and Debt Spree, Inc. Both firms have the same prospects for sales and EBIT, and both have the same level of assets, tax rate and borrowing rate.

They differ in their use of debt financing.

Scenario               Sales      EBIT

Bad year              200         12

Normal year       275         38

Good year           380         46

                Debt Free            Debt Spree

Total assets        250         250

Tax rate                35 %       35 %

Debt      0              150

Equity   250         100

Avg. interest rate             16 %       16 %

a) Calculate the interest expense for each firm.

b) Compute the return on assets (ROA) for each firm.

c) Compute the net income for each firm.

d) Compute the return on equity for each firm.

e) Which firm should have the higher CAPM ???? based on the information above, assuming they are both in the same industry and at the same stage in their lifecycle? Explain.

Problem 2.

An analyst with a mutual fund is considering buying a FCS Inc corporate bond. She has collected the balance sheet information and income statement info for FCS, as shown in Table 1 (values in thousands). Using the funds internal rating system, shown in Table 2, she computes a set of ratios to determine the appropriate risk premium for the bond.

Income Statement         

Revenue              $ 18,500

Operating and Admin. Expenses               $ 14,050

Operating Income before D&A  $ 4,450

Depreciation & Amortization      $ 1,675

Interest Expense             $ 942

EBT         $ 1,833

Taxes    $ 641

Net income        $ 1,192

Balance Sheet  

Current Assets  $ 4,735

Fixed Assets       $ 43,225

Total Assets        $ 47,960

Current Liabilities             $ 4,500

Long-term Debt                $ 10,000

Total Liabilities   $ 14,500

Shareholder Equity         $ 33,460

Total Liabilities & Shareholder Equity       $ 47,960

Table 1.

Rating Table                                                      

Bond Rating        Interest Coverage           Leverage             Current Ratio     Risk Premium

AA          5.0 to 6.0              0.25 to 0.30         1.15 to 1.25         0.30%

A             4.0 to 5.0              0.30 to 0.40         1.00 to 1.15         0.50%

BBB        3.0 to 4.0              0.40 to 0.50         0.90 to 1.10         1.00%

BB           2.0 to 3.0              0.50 to 0.60         0.75 to 0.90         1.25%

Table 2.

In the fund’s internal rating system, the interest coverage is defined as EBITDA divided by interest

expense. The leverage is defined as long-term debt divided by book value of equity. The current ratio is defined as current assets divided by current liabilities.

a) Compute the ratios to determine the appropriate bond rating for the FCS Inc bond.

The market debt ratio (MDR) is defined as the book value of total debt divided by the sum of the book value of total debt and the market value of equity. Assume that 1/3 of the current liabilities on FCS Inc’s balance sheet are short-term debt. Currently, FCS Inc’s MDR is 0.40. The beta of the company’s stock is 1.20. The bond is currently trading at a risk premium of 55 basis points

b) Assuming a risk-free rate of 3.0%, a market risk premium of 6.0%, and a tax rate of 25%, find the weighted average cost of capital.

c) FCS Inc has reached the stable growth stage. Its capital expenditures are 1.12x depreciation, and the change in net working capital is zero. Find the implied growth rate for the free cash flow to the firm (FCFF).