F1 Q16-Q18

Please show all workings/give explanations

Note: Questions 11 20 are based on the same mega problem. For convenience we have included the entire set of information in every question. For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other. This is the assumption we made in most of the videos to focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

Q16

You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you are seriously contemplating taking on the debt and using all of it to retire some shares. If you decide to enter this debt contract with the bank, what will be the capital structure, or debt-to-equity ratio, at t = 0 implied by this transaction? (Enter the number in percentage terms with up to two decimals but no % sign.)

Q17.

You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you decide to take on $3.50M of debt in perpetuity. The growth rate in the cash flows to equity holders between time t = 1 and time t = 2 will be (Enter the number in percentage terms with up to two decimals but no % sign.):

(For this question I got a correct answer of 3.49)

Q18.

Note: Questions 11 20 are based on the same mega problem. For convenience we have included the entire set of information in every question. For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other. This is the assumption we made in most of the videos to focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you decide to take on $3.50M of debt in perpetuity. The return on equity from t = 0 to t = 1 will be (Enter the number in percentage terms with up to two decimals but no % sign.):

Question	I got a correct answer of
17	3.49