Home Work Solution 2

Homework Assignment 2

Topic: Capital and Capital Structure and Payout Policy

Instructions:

* Handwritten homeworks have to be handed in to me in class

* Later hand-ins will NOT be accepted. No exceptions will be made

* If you can’t come to class, you have to leave the assignments in my mail box until 12:00.

* If you send scanned version of your assignments, please submit them to me via ITSLEARNING (same time 12:00).

* If you are unable to hand-in the assignment due to illness, you need to show a confirmation from your medical doctor.

* All subquestions have to be worked on. If you do not answer 1 subquestion, I will deduct 1 point, 2 unanswered subquestions lead to a deduction of 2 points, etc. If you do not answer more than 4 subquestions, you will not receive any credit for the assignment

Exercise 1:

Restex maintains a debt-equity ratio of 0.4, and has an equity cost of capital of 10% and a debt cost of capital of 7%. Restex’s corporate tax rate is 40%, and its market capitalization is $250 million.

a. If Restex’s free cash flow is expected to be $25 million in one year, what constant expected future growth rate is consistent with the firm’s current market value?

b. Estimate the value of Restex’s interest tax shield.

Answer:

A)

WACC= 11.410%+0.41.47%1-0.40=8.343%

VL=E+D= 250*1.4=350= FCFWACC-g=250.08343-g

g = 0.08343-25350=0.0120=1.2%

B)

VL = VU + PV(Interest Tax Shields)

Pretax WACC =11.410%+0.41.47%=9.143%

VU =FCFpretax WACC-g=250.09143-.0120=314.743 million

PV (Interest Tax Shield) = 350 – 314.743 = $35.257 million

Alternatively, you can calculate it as follows:

PVTax Shields=D×TC×rDPretax WACC-g=100×0.4×7%0.09143-0.012=35.257 million

Exercise 2:

Kurz Manufacturing is currently an all-equity firm with 10 million shares outstanding and a stock price of $12 per share. Although investors currently expect Kurz to remain an all-equity firm, Kurz plans to announce that it will borrow...