Investment timing option
1. Evans Industries is considering a new product that would require an investment of $25 million at t = 0. If the new product is well received, then the project would produce after-tax cash flows of $12.5 million at the end of each of the next 3 years (t = 1, 2, 3), but if the market did not like the product, then the cash flows would be only $5 million per year. There is a 60% probability that the market will be good. Evans could delay the project for a year while it conducted a test to determine if demand would be strong or weak. The project’s cost and expected annual cash flows are the same whether the project is delayed or not. The project’s WACC is 12%. What is the value of the project after considering the investment timing option?
2. Burlington Inc. is trying to establish its optimal capital structure. Its current capital structure consists of 30% debt and 70% equity; however, the CEO believes the firm should use more debt. The risk-free rate, rRF, is 4%, the market risk premium, RPM, is 5%, and the firm’s tax rate is 40%. Currently, the firm’s cost of equity is 11%, which is determined by the CAPM. What would be the firm’s estimated cost of equity if it changed its capital structure to 40% debt and 60% equity?
3. McCalister Corporation is an all-equity firm with 750,000 shares outstanding. The company’s EBIT is $3,000,000, and EBIT is expected to remain constant over time. The company pays out all of its earnings each year, so its earnings per share (EPS) equals its dividends per share (DPS). The company’s tax rate is 40%.
The company is considering issuing $2 million worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated YTM of 5.5%. The risk-free rate is 4.5%, and the market risk premium is 5.5%. The company’s beta is currently 0.95, but investment bankers say the beta will rise to 1.05 if the recapitalization occurs.
Assume that the shares are repurchased at a price equal to the stock market price prior to the recapitalization. What would be the company’s stock price following the recapitalization?
Residual dividend model: debt ratio
4. Claremont Company is forecasting EPS of $2.00 this year on its 300,000 shares of stock outstanding. Its capital budget for the upcoming year will be $500,000. The company is also committed to maintaining its $1.20 dividend per share (DPS), and it wants to avoid issuing new common stock. The company’s capital structure consists of debt and common stock. Given the above constraints, what portion of the capital budget will be funded with debt?
5. Which of the following statements is correct?
a. Firms with a large number of investment opportunities and a relatively small amount of cash tend to have above average dividend payout ratios.
b. One advantage of the residual dividend policy is that it leads to a stable dividend payout, which investors like.
c. Stock repurchases make the most sense at times when a company believes that its stock is undervalued.
d. If the “clientele effect” is correct, then for a company whose earnings fluctuate, a policy of paying a constant percentage of net income will probably maximize the stock price.
e. An increase in the stock price when a company decreases its dividend is consistent with signaling theory.
6. Burton Inc. is considering a project which would require a $10 million investment today (t = 0). The after-tax cash flows the factory generates will depend on whether the state imposes a new property tax. There is a 40% probability that the tax will pass. If the tax passes, the factory will produce after-tax cash flows of $1,500,000 at the end of each of the next 5 years. There is a 60% probability that the tax will not pass. If the tax does not pass, the factory will produce after-tax cash flows of $3,100,000 for the next 5 years. The project has a WACC of 10%. If the factory is unsuccessful, the firm will have the option to abandon the project 1 year from now if the tax passes. If the factory project is abandoned, the firm will receive the expected $1.5 million cash flow at t = 1, and the property will be sold netting $9 million (after taxes are considered) at t = 1. Once the project is abandoned, the company would no longer receive any cash inflows from it. What is the project’s expected NPV if it can be abandoned?
Calculating levered beta
7. If Duffert Inc. had no debt in its capital structure, its unlevered beta would be 0.65. However, the firm’s capital structure consists of 60% debt and 40% equity and it has a corporate tax rate of 40%. What is Duffert’s levered beta?
Financial leverage and EPS
8. Which of the following statements is correct?
a. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.
b. If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on the company’s return on assets. (Assume that the repurchase has no impact on the company’s operating income.)
c. The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price.
d. Increasing financial leverage is one way to increase a firm’s basic earning power (BEP).
e. Firms with lower fixed costs tend to have greater operating leverage.
9. Whittlesey Industries regularly takes real options into account when evaluating its proposed projects. Specifically, it considers the option to abandon a project whenever it turns out to be unsuccessful (the abandonment option), and it evaluates whether it is better to invest in a project today or to wait and collect more information (the investment timing option). Assume the proposed projects can be abandoned at any time without penalty. Which of the following statements is CORRECT?
a. Investment timing options always increase the value of a project.
b. A project can either have an abandonment option or an investment timing option, but never both.
c. If there are important first-mover advantages, this tends to increase the value of waiting a year to collect more information before proceeding with a proposed project.
d. The abandonment option tends to reduce a project’s risk.
e. The abandonment option tends to reduce a project’s NPV.
Residual dividend model: payout ratio
10. McKiever Industries has a capital budget of $1,500,000, but it wants to maintain a target capital structure of 55% debt and 45% equity. The company expects to pay a dividend of $450,000. If the company follows a residual dividend policy, what is its forecasted dividend payout ratio?