1. How does Apples accumulation of large amounts of cash reserves indicate that it might be following the Pecking Order Theory of Capital Structure determination? Why might some shareholders argue that the existence of those large cash reserves should actually be a call to the company to take on more debt and/or pay out more in cash dividends or share buybacks (hint: agency costs)?

2. Due to large losses incurred in the past several years, a firm has $5 billion in tax loss carryforwards. This means that the next $5 billion of income will be free from corporate tax. It is estimated that it will take many years for the firm to earn $5 billion in income (meaning that, for the foreseeable future, all income is untaxed). Given all of this information, if the company needs to raise new funds, would you recommend it issue debt or equity? Explain.

3. In class, we talked about how (using APV) financing leads to firms choosing to do some investment projects that they wouldnt do if they had to finance them completely through equity. Explain/show how this might be true. It is also true that sometimes offers additional incentives by offering subsidized loans to businesses. Explain/show how this would impact the number of projects that companies deemed viable.

4. When we compare debt-equity ratios across industries (the ones you are doing for your project), we saw significant differences in those ratios. What sorts of factors would help explain such differences? That is, why is it that some industries can finance much more with debt, but still have the same good bond ratings and low cost of debt as other industries that use much less debt in their capital structures?

5. Why is the value of a leveraged firm higher than the value of an unleveraged firm in a world with taxes? From where does this value difference arise and how do we value it? Does this mean that a firm would really want to issue as much debt as they possibly could? Explain what keeps that from happening (include relevant graphs in your explanations).

6. How can a company use an increase in debt to try to signal it believes future earnings will grow faster than previously expected? That is, why would investors see this debt increase as such a signal?

Section II: Answer all of the following

7. (10 Points) Look at Coca Cola (KO) and Pepsi (PEP), what have been their balance sheet debt-equity ratios over the past 10 years? What have been their market value debt-equity ratios over the past 10 years? Based on your results, do you find evidence of an ideal (sweet spot) capital structure in the soft drink industry or do you think the companies are following a different approach? Explain.

8. (10 Points) Doubleday Brewery is considering a new project. The company currently has a target debtequity ratio of .45, but the industry target debtequity ratio is .65. The industry average beta is 1.46. The market risk premium is 9.5 percent, and the (systematic) risk-free rate is 3.1 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 27 percent. The project will be financed at Doubledays target debtequity ratio. The project requires an initial outlay of $4,200,000 and is expected to result in a $405,000 cash inflow at the end of the first year. Annual cash flows from the project will grow at a constant rate of 3.5 percent until the end of the eighth year before leveling off at that same annual level (no longer growing) forever thereafter. Using the WACC methodology, value this project and tell whether it should be pursued.

9. (20 Points) Blue Rabbit Corporation is looking to build a toll road in Kentucky. The initial investment in paving equipment is $184 million. The equipment will be fully depreciated using the straight-line method over its economic life of ten years. Earnings before interest, taxes, and depreciation collected from the toll road are projected to be $19.25 million per annum for 20 years starting from the end of the first year. The corporate tax rate is 25 percent. The required rate of return for the project under all-equity financing is 8.82 percent.

This project could be privately financed by taking out a $100m loan over a nine-year period. The private, pretax cost of debt is 6.15 percent. Flotation costs would equal 1.4% of the loan total.

Alternatively, to encourage investment in the countrys infrastructure, the U.S. government could subsidize the project with a $100 million, 9-year loan at an interest rate of 4.85 percent per year with zero flotation costs.

For either loan, all principal will be repaid in one balloon payment at the end of Year 9.

1. What is the NPV of the all equity project? Explain whether you would proceed with the project if it was an all-equity project.
2. What is the value of this project using the private debt financing with equity? (Hint: APV) Explain whether you would pursue the project using this private debt financing.
3. What is the value of this project with the subsidized loan? Explain whether you would pursue the project with the subsidized loan.

10. (20 Points) Libby Co. is an unlevered firm. Investors currently expect a 12.75% return on the companys equity. The company is subject to a 24% corporate tax rate.

1. If earnings before taxes are expected to be $15.85m per year forever, calculate the total value of this company.

Now suppose this company wants to shift its capital structure to add debt. It wants to issue $31.5 million of perpetual debt at a cost of 5.5%.

2. Use the FTE method to calculate the value of the companys equity after the recapitalization.
3. What is the total value of the company after the recapitalization?
4. Using MMII with taxes, what should be the total value of the company after issuing the debt?
5. What is the debt-equity ratio of this company after the recapitalization?

Suppose the levered company is looking to invest in a new project. The project costs $27 million and will be financed at the debt-equity ratio you calculated in d. The project generates EBIT of $5.9 million in perpetuity.

6. Would you advise Libby to invest in this project? (Hint: use the FTE methodbe sure to show how much borrowing you will do and what annual interest costs will be).

11. (20 Points) Suppose an unleveraged company in a world without taxes has $180 million in assets.

1. With 8 million outstanding shares of stock, what is the price of each share?

2. Suppose the expected EBIT for this company is $20.5 million per year. Calculate each of the following:
   • ROA
   • ROE
   • EPS
   • WACC
   • Cost of Equity

3. Now, suppose you wish to shift the capital structure of this company, issuing $65 million in bonds and using the proceeds to buy up shares of stock. How many shares will be outstanding after this shift? (show)

4. If the interest rate on your debt is 8.75%, what is your expected EBT? (show)

5. Calculate each of the following for the newly leveraged firm:
   • ROA
   • ROE
   • EPS
   • WACC
   • Cost of Equity

6. Now, take the same firm, but put it in an environment where there is a 27% tax rate.

7. What is the value of the unleveraged firm in the world with taxes and what will be the price of each equity share?

8. Calculate each of the following for the unleveraged firm:
   • ROA
   • ROE
   • EPS
   • WACC
   • Cost of Equity

1. What is the value of the leveraged firm in the world with taxes and what will be the price of each equity share?

10. Calculate each of the following for the leveraged firm:

• ROA
• ROE
• EPS
• WACC
• Cost of Equity