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Problem 13-12 Agency Costs and Capital Structure 13.4 Agency Costs and Capital Structure Magnum Enterprises has net operating income of $6 million. There is $55 million of debt outstanding with a required rate of return of 6%. The required rate of return on the industry is 12%. The corporate tax rate is 45%; there are corporate taxes, but no personal taxes. Compute the value of Magnum assuming that the present value of bankruptcy costs is $9 million. Round your answer to nearest whole dollar. $ 2. Problem 13-13 Helpful Hints: The same concepts (as in question 1) apply here. However, the present value of bankruptcy costs needs to be determined here. For any given year, the expected value of bankruptcy costs will be equal to the probability of bankruptcy times the cost to the firm if bankruptcy occurs. Since bankruptcy can happen every year, the present value of bankruptcy costs, PVBR , will then be equal to the sum of the stream of discounted expected annual bankruptcy costs, where the discount rate will be the industry required return. Since we expect the same annual bankruptcy costs every year indefinitely, this stream, PVBR, is essentially a perpetuity. Note: When determining firm value, be aware that, here, there is no debt, so there won't be any \"PV (Tax Shield)\". Problem 13-13 Agency Costs and Capital Structure 13.4 Agency Costs and Capital Structure Slash and Burn Construction Company currently has no debt and expects to earn $10 million in net operating income each year for the foreseeable future. The required return on assets for construction companies of this type is 12.5%, and the corporate tax rate is 40%. There are no taxes on dividends or interest at the personal level. Slash and Burn calculates that there is a 10% chance the firm will fall into bankruptcy in any given year and that, if bankruptcy does occur, it will impose direct and indirect costs totaling $13 million. Assume that, in the event of bankruptcy, the firm will reorganize and continue operations indefinitely, with a constant 10% probability of reentering bankruptcy. If necessary, use the industry required return for discounting bankruptcy costs. a. Compute the present value of bankruptcy costs for Slash and Burn. $ b. Compute the overall value of the firm. $ 3. Problem 13-15 Helpful Hints: This question follows Question 2, but the firm is contemplating the usage of debts. Under the new proposals, obviously, \"PV (Tax Shield)\" would be positive. Problem 13-15 Agency Costs and Capital Structure 13.4 Agency Costs and Capital Structure Slash and Burn Construction Company currently has no debt and expects to earn $10 million in net operating income each year for the foreseeable future. The required return on assets for construction companies of this type is 12.5%, and the corporate tax rate is 40%. There are no taxes on dividends or interest at the personal level. Slash and Burn calculates that there is a 10% chance the firm will fall into bankruptcy in any given year and that, if bankruptcy does occur, it will impose direct and indirect costs totaling $16 million. Assume that, in the event of bankruptcy, the firm will reorganize and continue operations indefinitely, with a constant 10% probability of reentering bankruptcy. If necessary, use the industry required return for discounting bankruptcy costs. Assume that the managers of Slash and Burn Construction Company are weighing two capital structure alteration proposals, as follows. Proposal 1: Borrow $22 million at an interest rate of 6% and use the proceeds to repurchase an equal amount of outstanding stock. With this level of debt, the likelihood that Slash and Burn will fall into bankruptcy in any given year increases to 15%, and if bankruptcy occurs then it will impose direct and indirect costs totaling $14 million. Proposal 2: Borrow $28 million at an interest rate of 8% and use the proceeds to repurchase an equal amount of outstanding stock. With this level of debt, the likelihood of Slash and Burn falling into bankruptcy in any given year rises to 25%, and the associated direct and indirect costs of bankruptcy, should it occur, increase to $22 million. For each proposal, calculate the present value of the interest tax shields, bankruptcy costs and the overall value of the firm, assuming there are no personal taxes on debt or equity income. PVTS Proposal 1 $ PVBR $ V $ Proposal 2 PVTS $ PVBR $ V $ 4. Problem 15-2 Helpful Hints: Review the equations and example on PowerPoint Slide 13-3 (also Textbook Page 481). Problem 15-2 Payout Policy Fundamentals 15.1 Payout Policy Fundamentals Delta Corporation earned $2.50 per share during fiscal year 2009 and paid dividends of $0.75 per share. During the fiscal year that just ended on December 31, 2010, Delta earned $4.00 per share, and the firm's managers expect to earn this amount per share during fiscal years 2011 and 2012 as well. a. What was Delta's payout ratio for fiscal year 2009? % b. If Delta's managers wish to hold constant the dividend payout ratio, then what dividend per share will they declare for fiscal year 2011? $ per share Problem 15-3 Payout Policy Fundamentals 15.1 Payout Policy Fundamentals General Manufacturing Company (GMC) follows a policy of paying out 30% of its net income as dividends to its shareholders each year. The company plans to do so again this year, during which GMC earned $100 million in net profits after tax. The company has 30 million shares outstanding. a. What is the company's dividend payment per share this year? Round your answer to two decimal places. $ b. Assuming that GMC's stock price is $54 per share immediately before its ex-dividend date, what is the expected price of GMC stock on the ex-dividend date if there are no personal taxes on dividend income received? Round your answer to two decimal places. $ Problem 15-23 Payout Policy Irrelevance in a World with Perfect Capital Markets 15.2 Payout Policy Irrelevance in a World with Perfect Capital Markets Sam Sharp purchased 100 shares of Electric Lighting Inc. (ELI) one year ago for $40 per share, and he also received dividends of $8 per share since then. Now that ELI's stock price has increased to $45.4, Sam has decided to sell his holdings. What is Sam's gross (pretax) and after-tax return on this investment, assuming that he faces a 15% tax rate on dividends and capital gains? Round you answers to two decimal places. Gross % After-tax % Problem 15-25 Payout Policy Irrelevance in a World with Perfect Capital Markets 15.2 Payout Policy Irrelevance in a World with Perfect Capital Markets Jasper Metals Inc. just announced that it will pay its regular quarterly dividend of $2.50 per share. a. Does the stock price fall to reflect this payment on the announcement date, the record date, the ex-dividend date, or the payment date? b. Assume that there are no market imperfections. By how much will the stock price fall? Round your answer to the nearest cent. $ c. Suppose investors must pay a 36% tax on dividends received but pay nothing on capital gains. How would this change your answer to part (b)? Round your answer to the nearest cent. $ d. Now suppose that investors must pay 36% in taxes on both dividends and capital gains. In this case, how much would you expect the stock price to fall in response to the dividend? Round your answer to the nearest cent. $ e. Suppose that, just prior to the dividend announcement, Jasper Metals stock was worth $175 per share. Assume once again that there are no taxes. If you own 50 shares, then what is the value of your investment? $