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Homework Assignment 2

Topic: Capital and Capital Structure and Payout Policy


Instructions:
Later hand-ins will NOT be accepted. No exceptions will be
made
If you cant 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 helge.ratvik@gmail.com.
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%. Restexs
corporate tax rate is 40%, and its market capitalization is $250
million.
a.

If Restexs free cash flow is expected to be $25 million in


one year, what constant expected future growth rate is
consistent with the firms current market value?

b.

Estimate the value of Restexs interest tax shield.

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 $50 million and use the funds
to repurchase shares. Kurz will pay interest only on this debt, and it
has no further plans to increase or decrease the amount of debt.
Kurz is subject to a 40% corporate tax rate.
a.

What is the market value of Kurzs existing assets before


the announcement?

b.

What is the market value of Kurzs assets (including any


tax shields) just after the debt is issued, but before the
shares are repurchased?

c.

What is Kurzs share price just before the share


repurchase? How many shares will Kurz repurchase?

d.

What are Kurzs market value balance sheet and share


price after the share repurchase?

Exercise 3:
Gladstone Corporation is about to launch a new product. Depending
on the success of the new product, Gladstone may have one of four
values next year: $110 million, $80 million, $75 million, and $40
million. These outcomes are all equally likely, and this risk is
diversifiable. Suppose the risk-free interest rate is 2.5% and that, in
the event of default, 25% of the value of Gladstones assets will be
lost to bankruptcy costs. (Ignore all other market imperfections,
such as taxes.)
a.
What is the initial value of Gladstones equity without
leverage?
Now suppose Gladstone has zero-coupon debt with a
$75 million face value due next year.
b.

What is the initial value of Gladstones debt?

c.

What is the yield-to-maturity of the debt? What is its


expected return?

d.

What is the initial value of Gladstones equity? What is


Gladstones total value with leverage?

Suppose Gladstone has 10 million shares outstanding and no


debt at the start of the year.
e.

If Gladstone does not issue debt, what is its share price?

f.

If Gladstone issues debt of $75 million due next year


and uses the proceeds to repurchase shares, what will
its share price be? Why does your answer differ from
that in part (e)?

Exercise 4:
Zymase is a biotechnology start-up firm. Researchers at Zymase
must choose one of three different research strategies. The payoffs
(after-tax) and their likelihood for each strategy are shown below.
The risk of each project is diversifiable.
Strategy

Probability

Payoff ($ million)

100%

110

50%

180

50%

20%

310

80%

20

a.

Which project has the highest expected payoff?

b.

Suppose Zymase has debt of $50 million due at the time


of the projects payoff. Which project has the highest
expected payoff for equity holders?

c.

Suppose Zymase has debt of $100 million due at the


time of the projects payoff. Which project has the
highest expected payoff for equity holders?

d.

If management chooses the strategy that maximizes the


payoff to equity holders, what is the expected agency
cost to the firm from having $50 million in debt due?
What is the expected agency cost to the firm from
having $100 million in debt due?