Backcountry Adventures is a Colorado-based outdoor travel agent that operates a series of winter backcountry huts.Currently, the value of the firm (debt + equity) is $3.5 million.But profits will depend on the amount of snowfall: If it is a good year, the firm will be worth $5 million, and if it is a bad year it will be worth $2.5 million.Suppose managers always keep the debt to equity ratio of the firm at 25%, and the debt is riskless.

a.What is the initial amount of debt?

b.Calculate the percentage change in the value of the firm, its equity and its debt once the level of snowfall is revealed, but before the firm adjusts the debt level to achieve its target debt to equity ratio.

c.Calculate the percentage change in the value of outstanding debt once the firm adjusts to its target debt-equity ratio.

d.What does this imply about the riskiness of the firm?s tax shields?Explain.

1.Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely.The initial investment required for the project is $80,000, and the project's cost of capital is 15%.The risk-free interest rate is 5%.

a.What is the NPV of the project?

b.Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. The equity holders will receive the cash flows of the project in one year.What is the market value of the unlevered equity for this project?

c.Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk free rate.What cash flows will equity holders receive in one year in a weak economy?

d.In a strong economy?

e.Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk free rate.What is the cost of capital for the firm's levered equity?

2.Galt Industries has 50 million shares outstanding and a market capitalization of $1.25 billion.It also has $750 million in debt outstanding.Galt Industries has decided to delever the firm by issuing new equity and completely repaying all the outstanding debt.

a.How many shares must the firm issue?

b.Suppose you are a shareholder in Galt industries holding 100 shares, and you disagree with this decision to delever the firm.How do you undo the deleveraging?

3.Rosewood Industries has EBIT of $450 million, interest expense of $175 million, and a corporate tax rate of 35%.

a.Rosewood's net income is:

b.The total of Rosewood's net income and interest payments is:

c.If Rosewood had no interest expense, its net income is:

d.The amount of Rosewood's interest tax shield is:

4.Kinston Enterprises has no debt and a debt obligation of $47 million that is due now.The market value of Kinston's assets is $102 million, and the firm has no other liabilities.Assume that capital markets are perfect and that Kinston has 5 million shares outstanding.What is Kinston's current share price?

5.Taggart Transcontinental has a value of $500 million if it continues to operate, but has outstanding debt of $600 million. If Taggart declares bankruptcy, bankruptcy costs will equal $50 million, and the remaining $450 million will go to creditors. Instead of declaring bankruptcy, Taggart proposes to exchange the firm's debt for a fraction of its equity in a workout. What is the minimum fraction of the firm's equity that Taggart would need to offer to its creditors for the workout to be successful?

6.Suppose that you have received two job offers. Rearden Metal offers you a contract for $75,000 per year for the next two years while Wyatt Oil offers you a contract for $90,000 per year for the next two years. Both jobs are equivalent. Suppose that Rearden Metal's contract is certain, but Wyatt Oil has a 60% chance of going bankrupt at the end of the year. In the event that Wyatt Oil files for bankruptcy, it will cancel your contract and pay you the lowest amount possible for you to not quit. If you do quit, you expect you could find a new job paying $75,000 per year, but you would be unemployed for four months while searching for this new job.

a.If you take the job with Wyatt Oil, then, in the event of bankruptcy, the least amount that Wyatt Oil would pay you next year is:

b.Assuming your cost of capital is 6 percent, the present value of your expected wage if you accept Rearden Metal's offer is:

c.Assuming your cost of capital is 6 percent, the present value of your expected wage if you accept Wyatt Oil's offer is closest to:

d.Assuming your cost of capital is 6 percent, which job should you take?

7.d'Anconia Copper is considering issuing one year debt, and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt:

a.If in the event of distress, the present value of distress costs is equal to $10 million, then the optimal level of debt for d'Anconia Copper is:

b.If in the event of distress, the present value of distress costs is equal to $5 million, then the optimal level of debt for d'Anconia Copper is:

c.If in the event of distress, the present value of distress costs is equal to $25 million, then the optimal level of debt for d'Anconia Copper is:

8.Omicron Technologies has $50 million in excess cash and no debt.The firm expects to generate additional free cash flows of $40 million per year in subsequent years and will pay out these future free cash flows as regular dividends.Omicrons unlevered cost of capital is 10% and there are 10 million shares outstanding.Omicron's board is meeting to decide whether to pay out its $50 million in excess cash as a special dividend or to use it to repurchase shares of the firm's stock.

a.Omicron's enterprise value is:

b.Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend.The amount of the special dividend is:

c.Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend.Omicron's ex-dividend price is:

d.Assume that Omicron uses the entire $50 million to repurchase shares.The number of shares that Omicron will repurchase is:

e.Assume that you own 2500 shares of Omicron stock and that Omicron uses the entire $50 million to repurchase shares.Suppose you are unhappy with Omicron's decision and would prefer that Omicron used the excess cash to pay a special dividend.The number of shares that you would have to sell in order to receive the same amount of cash as if Omicron paid the special dividend is:

9.

Omicron Industries' Market Value Balance Sheet ($ Millions)

and Cost of Capital

Assets

Liabilities

Cost of Capital

Cash

0

Debt

200

Debt

6%

Other Assets

500

Equity

300

Equity

12%

?c

35%

Omicron Industries New Project Free Cash Flows

Year

0

1

2

3

Free Cash Flows

($100)

$40

$50

$60

Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.

a.Omicron's weighted average cost of capital is:

b.The NPV for Omicron's new project is:

c.The Debt Capacity for Omicron's new project in year 0 is:

d.The Debt Capacity for Omicron's new project in year 1 is:

e.The Debt Capacity for Omicron's new project in year 2 is:

10.Consider the information for the following four firms:

Firm

Cash

Debt

Equity

rD

rE

?c

Eenie

0

150

150

5%

10%

40%

Meenie

0

250

750

6%

12%

35%

Minie

25

175

325

6%

11%

35%

Moe

50

350

150

7.50%

15%

30%

a.The unlevered cost of capital for "Eenie" is:

b.The levered cost of capital for "Moe" is: