I have included 5 attachments with 5 questions/answers each. I need to know the steps and formulas used to solve each of the questions with all work shown please. Word documents only please. Thank you!

Session 17: Post Class tests 1. Assume that the legislators are looking at enacting a new tax law, aimed at getting companies to pay out more of their earnings as dividends. As part of this law, companies will pay two different tax rates on net income: a 35% tax rate on retained earnings and a 15% tax rate on earnings paid out as dividends. What effect will this have on corporate financing behavior? a. None. Debt ratio should remain unchanged b. Debt ratios should go up over time, as companies pay more dividends c. Debt ratios should go down over time. 2. Asker Inc. is an all-equity funded firm that is considering borrowing $ 1 billion at a market interest rate of 6%. If the loan is a balloon payment loan for 10 years (only interest paid for the next 10 years and the principal at the end of year 10) and Asker faces a 40% marginal tax rate, what is the value of the tax benefits that Asker will get just from the ten-year loan? a. $24 million b. $176.64 million c. $240.00 million d. $264.96 million e. $1 billion 3. The argument for debt as a mechanism to discipline management is built around the premise that stockholders generally have little power over managers. If this argument holds true, a company that borrows more money should a. Invest more in good projects after the borrowing b. Invest less in good projects after the borrowing c. Invest more in bad projects after the borrowing d. Invest less in bad projects after the borrowing e. None of the above 4. A cost that has to be weighed into the debt decision is the expected cost of bankruptcy. As that cost rises, companies should borrow less money. Assume that you are looking at a European power company that has historically enjoyed monopoly power and has funded itself with a significant amount of debt. The power market has now been opened up to competition. What change would you expect to see in the company's debt policy? a. None. It is still a profitable company b. Debt ratio should go up. c. Debt ratio should go down. Explain. 5. Agency costs arise any time there is a conflict between stockholder interests and lender interests. Assuming that agency costs are high at a company, relative to the rest of the market, which of the following would you expect to observe with the company's borrowing? a. It will be able to borrow less than other companies b. It will have to pay higher interest rates on its loans than otherwise similar companies c. It will face more \"covenants\" than otherwise similar companies d. All of the above e. None of the above 6. The Miller Modigliani theorem posits that debt policy is irrelevant, when it comes to firm value. Assume that you have a firm that is funded entirely with equity and has a beta (unlevered) of 0.90; the risk free rate is 3% and the equity risk premium is 6%. What will happen to the cost of capital, if the firm moves to a 30% debt ratio? (Remember that there are no taxes or default risk in the Miller Modigliani world). a. The cost of capital will remain unchanged b. The cost of capital will go up c. The cost of capital will go down Can you provide proof? 7. In a world with no taxes, default risk or agency costs, Miller and Modigliani argue that your debt ratio is irrelevant and that your firm value will remain unchanged as the debt ratio changes. Assume now that you introduce tax benefits for debt and that you insure firms against default, what would you expect the right mix of debt and equity to be for a firm which is fully protected against bankruptcy? a. Debt would still be irrelevant. b. The firm should be all equity funded c. The firm should be all debt funded. Session 17: Post class test solutions 1. c. Debt ratios should go down over time. The lower tax rate on dividends effectively lowers the cost of equity. Since the after-tax cost of debt does not change, this will make debt a less attractive choice to all companies and even more so for mature companies that can afford to pay high dividends. 2. b. $176.64 million. The interest tax savings each year can be computed by multiplying the interest expense by the marginal tax rate: Interest tax savings = 60*.4 = $24 million Taking the present value of these savings over 10 years at the pre-tax cost of debt (assumed to measure the risk in the tax savings as well), you get: PV of savings = $24 m (PV of annuity, 10 years, 6%) = $176.64 m 3. d. Invest less in bad projects after the borrowing. The idea behind using debt as a disciplinary mechanism is more to prevent taking bad projects than to induce taking good projects. In fact, borrowing more money may sometimes cause companies to invest less in good projects (making choice b a viable one) especially if these good projects are in risky businesses. 4. c. Debt ratio should go down. As competition heats up, the profits of the hitherto monopoly company will become more volatile. In expected bankruptcy terms, the probability of default has gone up at every level of debt making the expected costs of bankruptcy higher. 5. d. All of the above. When agency costs go up, it is the borrower who bears the brunt of the cost and it takes all forms. Lenders will lend less money, charge higher interest rates and write in more covenants, if they are concerned about where their money is going. 6. c. The cost of capital will remain unchanged. To prove it, start with the cost of capital at a zero debt ratio. With the unlevered beta of 0.90: Cost of equity = Cost of capital = 3%+0.9*6% = 8.4% If the firm moves to any debt to capital ratio (say 20%), it will be borrowing at the risk free rate of 3% (since there is no default risk) and the levered beta will rise Levered beta = 0.90 (1+ (1-0) (20/80)) = 1.125 Cost of equity = 3% +1.125 (6%) = 9.75% Cost of capital = 9.75% (.8) + 3% (.2) = 8.4% 7. c. The firm should be all debt funded. If you give debt the tax benefits and not offset it with expected bankruptcy costs, firms should be predominantly debt funded.. Session 18: Post Class tests 1. The objective in corporate finance is to maximize the value of the business. In the standard cost of capital approach to financing, we argue that the optimal debt ratio is the one that minimizes the cost of capital. For this approach to yield the optimal, which of the following assumptions do you need to make? a. The bond rating of the firm will not change as the debt ratio changes b. The operating income of the firm will not change as the debt ratio changes c. The net income for the firm will not change as the debt ratio changes d. The beta will not change as the debt ratio changes e. None of the above 2. In the cost of capital approach, you estimate the cost of equity and the cost of debt at each debt ratio and the resulting cost of capital. As you increase the debt ratio, which of the following is most likely to happen? a. Cost of equity and cost of debt will both decrease b. Cost of equity and cost of debt will both increase c. Cost of equity will go down but the cost of debt will go up d. Cost of equity will go up and the cost of debt will remain unchanged e. Cost of equity will go up but the cost of debt will go down 3. You are trying to evaluate Farmingdale Inc., a publicly traded company, with a 20% debt to capital ratio, a marginal tax rate of 40% and a beta (levered) of 1.15 , which is considering a move to a 33.33% debt to capital ratio. What will the beta of the firm be after the move to 33.33% debt? a. 1.15 b. 1.20 c. 1.30 d. 1.495 e. None of the above 4. Thadeus Inc. is a publicly traded chemical company with a bond rating of AA and a pre-tax cost of debt of 3.50% at its existing debt to capital ratio of 40% ($400 million debt & $ 600 million equity). The firm has operating income of $70 million and is considering borrowing $ 200 million and buying back stock. If it does so, what will the interest coverage ratio for the firm be, assuming that the firm's rating will drop to BBB and that the interest for BBB rated bonds is 5%? a. 2.33 b. 2.67 c. 2.92 d. 3.33 e. None of the above 5. Morigas Inc. is a publicly traded firm that expects to earn $10 million in operating income and pay a marginal tax rate of 40%. The firm has $100 million in debt, at a 5% interest rate, and is planning to double its debt. If the expected interest rate on the debt will rise to 7.5% on all debt after the debt doubling, what will the after-tax cost of debt for the firm be after the borrowing? a. 3.00% b. c. d. e. 3.75% 4.50% 5.50% None of the above Session 18: Post class test solutions 1. b. The operating income of the firm will not change as the debt ratio changes. For a lower cost of capital to result in higher firm value, the operating cash flow of the firm will have to remain fixed (or unchanged) as the debt ratio changes. For operating cash flow to not change, operating income has to be fixed as the debt ratio changes. 2. Cost of equity and debt will both increase. The latter will go up because you are borrowing more money and increasing your default risk. The cost of equity will increase because borrowing more money will create interest expenses, which, in turn, will make equity earnings more volatile. 3. c. 1.30. If the debt to capital ratio now is 20%, the debt to equity ratio is 25% (20/80). To get the new beta, you first have to unlever the existing beta: Unlevered beta = 1.15/ (1 + (1-.4) (.25)) = 1.00 The new debt to capital ratio is 33.33%, resulting in a debt to equity ratio of 50%. Relever back at the new debt ratio of 50%: Levered beta = 1.00 (1+ (1-.4) (.50)) = 1.30 4. c. 2.92 (mechanical answer), a. 2.33 (better answer). To get the mechanical answer, you keep the existing debt of $400 million at the old interest rate of 3.5% and add the new debt of $200 million at the new interest rate of 5%: Interest expenses = .035(400) + .05 (200) = $24 million Interest coverage ratio = 70/24 = 2.92 However, it is unlikely that the old debt holders will settle for the old interest rate. As the debt gets refinanced (forcibly or with the passage of time), the interest rate on all of the debt will converge on 5% Interest expenses = .05 (600) = 30 Interest coverage ratio = 70/30 = 2.33 5. d. 5.5%. To get to this answer, first recognize that if the firm doubles it debt and the interest rate doubles, the interest expense will be higher than the operating income: Interest expense on debt = 200 (.075) = 15 Operating income = Maximum interest tax deduction = 10 Tax savings on maximum deduction = 10 (.40) = $4 million Adjusted marginal tax rate on all interest expense = 4/15 = 26.67% After-tax cost of debt = 7.50% (1-.2667) = 5.5% Session 19: Post Class tests 1. Simac Inc. is a publicly traded company and its current cost of capital is 9%. You have computed the optimal debt ratio for the firm to be 40% and the cost of capital at the optimal is 8%. If the firm is mature (with expected free cash flows growing 2% a year in perpetuity), how much will Simac's firm value increase by, on a percentage basis, if it moves to its optimal? a. 11.1% b. 12.5% c. 16.67% d. 25% e. None of the above 2. Assume that Lyric Inc., a publicly traded company, has 10 million shares, trading at $20/share and that it has $50 million in debt. You believe that the value of Lyric will increase by 10% if it borrows $50 million and buys back stock. Assuming investors are rational, what would you expect to pay, per share, on the stock buyback? a. $20/share b. $21.875/share c. $22.50/share d. $23.33/share e. $25/share f. None of the above 3. In the last example, assume that you plan to buy the shares back at $25/share. If you do so, what would you expect the remaining shares in the company to trade at, after the buy back? a. $20/share b. $21.88/share c. $22.50/share d. $23.33/share e. $25/share f. None of the above 4. One way companies protect themselves from borrowing too much is to put a constrain the bond rating, i.e., not allow the debt ratio to increase so much that the rating (synthetic or estimated) drops below the rating constraint. For a non- financial service company, that rating constraint is often investment grade (BBB). Which of the following reasons explains this rating constraint? a. Your access to capital is more limited if you are not investment grade. b. Your cost of debt can rise significantly once you drop below investment grade. c. If your rating drops below investment grade, your customers may hold back on buying your product or service. d. If your rating drops below investment grade, suppliers may be less willing to extend credit (and will demand cash instead) e. All of the above. 5. Cain & Abel Inc. is in the hotel and entertainment businesses and has an actual debt ratio of 10%. You have computed an optimal debt ratio of 40% for the firm, based on its existing operating income, risk and assets. The company is planning to make investments with the excess debt capacity rather than recapitalize itself (by buying back stock). Under which of the following scenarios would your optimal debt ratio remain unchanged? a. An acquisition of a company in a different business. b. An expansion of the hotel business c. An expansion of the entertainment business d. Expansion of both the hotel and entertainment businesses, in line with their existing weights in the business e. None of the above f. Any of the above Session 19: Post class test solutions 1. c. 16.67%. To show this, assume that the firm is expected to have $1 in cash flow next year. Value at current cost of capital = 1/ (.09-.02) = 14.29 Value at optimal = 1/ (.08-.02) = 16.67 % change in value = (16.67/14.29)-1 = 16.67% 2. c. $22.50/share. If investors are rational, the increase in firm value has to be spread equally among those who sell their shares back and those who do not. Increase in value/share = 25/ 10 = $2.50 New stock price = $22.50 Here is a way to confirm that you are right: Number of shares outstanding after buyback = 10 - (50/22.5) = 7.778 million Value of firm after buyback = 250 + 25 = 275 Value of debt after buyback = 100 Value of equity after buyback - 275 -100 = 175 Value per share of remaining shares = 175/ 7.7778 = $22.50 3. b. $21.88. Here is the simplest way to show this: Number of shares outstanding after buyback = 10 - (50/25) = 8 million Value of firm after buyback = 250 + 25 = 275 Value of debt after buyback = 100 Value of equity after buyback - 275 -100 = 175 Value per share of remaining shares = 175/ 8= $21.875 4. e. All of the above. While the costs can vary across companies, dropping below investment grade can make your indirect bankruptcy costs increase significantly. 5. Expansion of both the hotel and entertainment businesses, in line with their existing weights in the business. The optimal debt ratio is based on the existing operating income, risk and assets. Only with a proportional expansion is there a chance that all three of these will stay stable. Session 20: Post Class tests 1. When computing the optimal debt ratio for a firm in the standard cost of capital approach, we keep operating income fixed while varying the cost of capital, thus ignoring the effect of increased default risk on operations. One way of incorporating this \"indirect\" bankruptcy cost into your analysis is to assume that operating income will decrease as a company's bond rating drops. If you allow for this effect, which of the following would you expect to generally see happen to the optimal debt ratio? a. The optimal debt ratio will go down b. The optimal debt ratio will remain unchanged c. The optimal debt ratio will go up d. Any of the above 2. You are assessing the optimal debt ratio for an oil company, using the cost of capital approach. A key driver of this optimal debt ratio is the operating income that you attribute to this firm. In coming up with an optimal, which of the following measures of operating income will yield the \"best\" estimate of optimal debt ratio? a. Operating income in the most recent fiscal year b. Operating income in the most recent 12 months c. Highest operating income earned over an oil price cycle d. Lowest operating income earnings over an oil price cycle e. Average operating income earned over an oil price cycle 3. Young, growth companies generally do not borrow much money. Does it follow that they are also likely to be under levered? a. Yes b. No Explain. 4. Banks, investment banks and insurance companies treat debt as raw material, rather than a source of capital. To assess how much new equity these financial service companies have to raise in markets, we have to look at regulatory capital requirements and growth potential. Which of the following financial service firms will have the greatest need for new equity in the future? a. A mature, under capitalized bank b. A mature, over capitalized bank c. A high growth, under capitalized bank d. A high growth, over capitalized bank 5. The equity risk premium (ERP) is the price for risk in the equity bond market, while default spreads are the price for risk in the bond market. Holding all else constant, under which of the following scenarios would you expect companies to use the most debt (relative to equity)? a. When the ERP and default spreads are both high b. When the ERP and default spreads are both low c. When the ERP is high and default spreads are low d. When the ERP is low and default spreads are high Session 20: Post class test solutions 1. a. The optimal debt ratio will generally decrease. If the operating income also drops as the rating drops, you are increasing the \"cost\" of borrowing, while holding the benefits constant. While it is possible that your optimal is at a high enough rating that you are not affected, the optimal debt ratio will generally decrease. 2. e. Average operating income over an oil price cycle. Your objective is not to borrow money based on your last year's income your best year's income or your worst year's income but to borrow money based upon what you can make in an average year. You will have too much debt in the bad years and too little in the good years, but you should be able to use the latter to buffer the former. 3. b. No. Young, high growth companies also have low operating income, relative to their market values. Consequently, they cannot afford to borrow much money and their optimal debt ratios also tend to be low or even zero. 4. c. A high growth, under capitalized bank. Under capitalized banks that are in high growth will need to add more to their regulatory capital bases. Some of that addition can come from retained earnings, but if the growth is high enough and the under capitalization large enough, they will have to raise fresh equity capital. 5. c. When the ERP is high and default spreads are low. The high price of risk in the equity market, relative to the corporate bond market, will make it more attractive to companies to raise debt (and retire equity). Session 21: Post Class tests 1. In the adjusted present value approach (APV), you value the firm without debt (unlevered firm value) and then bring in the effects of debt by considering the value of the tax benefits of debt and the expected bankruptcy costs. In practice, faced with difficulties when estimating expected bankruptcy cost, analysts choose to ignore it and consider only the tax benefit component of debt. If you consider only the tax benefits in your APV assessment, which of the following will you find to be your optimal debt ratio? a. No debt b. 100% debt c. Debt will have no effect on value d. Any of the above 2. Vaughn Enterprises is an all-equity funded firm with 100 million shares outstanding, trading at $10/share. The company is planning on borrowing $400 million and buying back shares. The marginal tax rate for the firm is 40% and the cost of bankruptcy as a percent of unlevered firm value is 30%. If the new market capitalization for the firm will be $700 million, after the buyback, what is the probability of bankruptcy after the buyback? (Use the standard APV assumption about the tax benefits of debt) a. 0% b. 10% c. 18.18% d. 20% e. 28.57% f. None of the above 3. Lizzie Inc. is an apparel manufacturer with 200 million shares outstanding, trading at $15/share and $1.2 billion in debt outstanding (in market value terms). If the marginal tax rate for the firm is 40%, the cost of bankruptcy is 20% of current firm value and the probability of bankruptcy at the current debt level is 25%, what is the unlevered value of the firm? a. $2,670 million b. $3,930 million c. $4,200 million d. $4,470 million e. None of the above 4. Sizzle Media is a media company that has a market capitalization of $900 million and debt outstanding of $100 million. The average debt ratio for media companies is 37%. Which of the following provides a likely explanation for why Sizzle Media should have a lower debt ratio than the average media company? a. Sizzle Media has a higher effective tax rate than the typical media company b. There are fewer insider investors in Sizzle Media than in the typical media company c. Sizzle Media has more stable income than the typical media company d. Sizzle Media is a larger company than the typical media company e. Sizzle Media is more dependent on movie making and has fewer physical assets than the typical media company f. None of the above g. All of the above 5. You have run a regression of debt to capital ratios against independent variables, across all companies in the market, and arrived at the following: Debt to Capital Ratio = 0.40 + 0.25(Effective Tax Rate) - 0.15 (Insider holdings as % of shares outstanding) - 0.20 (Standard deviation in operating earnings) Felter Inc. has an effective tax rate of 30%, insider holdings are 10% of outstanding shares and you have estimated a standard deviation of 50% in the firm's operating earnings. What is the optimal debt ratio for Felter Inc., based upon the market regression? (Enter the percentage values as decimals; thus, 20% is entered as 0.20) a. 36% b. 39% c. 40% d. 56% e. None of the above Session 20: Post class test solutions 1. b. 100% debt. Since you are counting in the benefits of debt and are assuming no costs, debt can only increase value (The only exception is if you have a zero tax rate, in which case it will have no effect on value). 2. d. 20%. Set up the equation for the value of the levered firm Value of levered firm = Value of unlevered firm + Debt * Tax Rate - Probability of bankruptcy * Cost of bankruptcy 700 + 400 = 100*10 + 400*.4 - Probability of bankruptcy (.3)(1000) Probability of bankruptcy = 60/300 = 20% 3. b. $3,930 million. The unlevered firm value can be obtained from the firm value by subtracting out the tax benefits of debt and adding back the expected bankruptcy costs (you will lose both when you have no debt) Value of levered firm = 3000 +1200 Tax benefit = 1200*.4 Expected cost of bankruptcy = .25*.20*4200 = $210 Value of unlevered firm = 4200 - 480 + 210 = $3,930 million 4. e. Sizzle Media is more dependent on movie making and has fewer physical assets than the typical media company. The fact that the firm has less in physical assets increases agency costs associated with borrowing and thus will lead Sizzle Media to have less debt. 5. a. 36%. Plugging into the market regression: Optimal debt ratio = 0.4+0.25*0.3-0.15*0.1 - 0.2*0.5 = 0.36