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Corporate Finance / Financial Resources Part 2 Assignment 4: Debt and Taxes Reading: Take a look at the addition to Lecture 4. It is about \"Agency Issues.\" This is not mandatory material, but you might have an interest in it. Please explain concisely but clearly all of your answers. I am not expecting perfection as long as your train of thought is sound. Problem 1 (The interest tax deduction) 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 closest to: (1) $450 million (2) $180 million (3) $290 million (4) $95 million (b) The amount of Rosewood's interest tax shield is closest to: (1) $115 million (2) $290 million (3) $175 million (4) $61 million Problem 2 (The interest tax deduction) Fly by Night Aviation (FBNA) expects to have net income next year of $24 million and total income available to all investors (interest expense plus net income) of $27 million. FBNA's marginal corporate tax rate is 40%. (a) FBNA's EBIT is closest to: (1) $43 million (2) $40 million (3) $45 million (4) $60 million (b) If FBNA increases leverage so that its interest expense rises by $1 million, then the amount its net income will change is closest to: (1) -$400,000 (2) -$600,000 (3) $400,000 (4) $600,000 (c) If FBNA increases leverage so that its interest expense rises by $1 million, then the amount of income available to all investors will change by about: (1) -$600,000 (2) -$400,000 (3) $600,000 (4) $400,000 Problem 3 (Debt, corporate taxes, and the value of the firm) Flagstaff Enterprises is expected to have free cash flows in the coming year of $8 million, and this free cash flow is expected to grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and is in the 35% corporate tax bracket. (a) If Flagstaff maintains a .5 debt to equity ratio, then Flagstaff's pre-tax WACC is closest to: (1) 10.5% (2) 11.0% (3) 9.0% (4) 10.0% (b) If Flagstaff currently maintains a .5 debt to equity ratio, then the value of Flagstaff as an all equity firm would be closest to: (1) $80 million (2) $100 million (3) $73 million (4) $115 million (c) If Flagstaff currently maintains a .5 debt to equity ratio, then Flagstaff's after-tax WACC is closest to: (1) 10% (2) 10.25% (3) 9.50% (4) 8.75% (d) If Flagstaff currently maintains a .5 debt to equity ratio, then the value of Flagstaff as a levered firm is closest to: (1) $114 million (2) $100 million (3) $111 million (4) $140 million (e) If Flagstaff currently maintains a .5 debt to equity ratio, then the value of Flagstaff's interest tax shield is closest to: (1) $11 million (2) $18 million (3) $10 million (4) $24 million Problem 4 (Debt, corporate and personal taxes, and the value of the firm) KD Industries has 30 million shares outstanding with a market price of $20 per share and no debt. KD has had consistently stable earnings, and pays a 35% tax rate. Management plans to borrow $200 million on a permanent basis through a leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares. Assuming that the interest income tax is 35% and the average tax on equity income is 15%, calculate the present value of the interest tax shield provided by KD's recapitalization. Problem 5 (Debt, bankruptcy, and the value of the firm) Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy and the cost of capital is equal to the risk-free rate, which is currently 5%. Assume that capital markets are perfect. (a) The initial value of MI's equity without leverage is closest to: (1) $133 million (2) $147 million (3) $140 million (4) $150 million (b) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI's debt is closest to: (1) $125 million (2) $111 million (3) $100 million (4) $116 million (c) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI's equity is closest to: (1) $30 million (2) $15 million (3) $29 million (4) $24 million (d) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The total value of MI with leverage is closest to: (1) $133 million (2) $140 million (3) $147 million (4) $125 million (e) Assuming that in the event of default, 20% of the value of MI's assets will be lost in bankruptcy costs, the initial value of MI's equity without leverage is closest to: (1) $150 million (2) $147 million (3) $140 million (4) $133 million (f) Assume that in the event of default, 20% of the value of MI's assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The total value of MI with leverage is closest to: (1) $140 million (2) $100 million (3) $125 million (4) $134 million (g) Assume that in the event of default, 20% of the value of MI's assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The present value of MI's financial distress cost is closest to: (1) $20 million (2) $6.6 million (3) $6.3 million (4) $19 million Problem 6 (The trade-off theory) Big Blue Banana (BBB) is a clothing retailer with a current share price of $10.00 and with 25 million shares outstanding. Suppose that BBB announces plans to lower its corporate taxes by borrowing $100 million and using the proceeds to repurchase shares. Suppose that BBB pays corporate taxes of 40% and shareholders expect the change in debt to be permanent. Assume that capital markets are perfect except for the existence of corporate taxes and financial distress costs. If the price of BB's stock rises to $10.80 per share following the announcement, then what is the present value of BBB's financial distress costs