In the problems following, use an equity risk premium of 5.5 percent if none is specified.

1. XYZ Corporation has $500 million in zero coupon debt outstanding, due in five years. The firm had earnings before interest and taxes of $40 million in the most recent year (the tax rate is 40%). These earnings are expected to grow 5% a year in perpetuity, and the firm paid no dividends. The firm had a return on capital of 12% and a cost of capital of 10%. The annualized standard deviation in firm values of comparable firms is 12.5%. The five-year bond rate is 5%.

a. Estimate the value of the firm.

b. Estimate the value of equity, using an option pricing model.

c. Estimate the market value of debt and the appropriate interest rate on the debt.

2. Atlantic Cruise Lines operates cruise ships and is headquartered in Florida. The firm had $100 million in pretax operating income in the current year, of which it reinvested $25 million. The firm expects its operating income to grow 4% in perpetuity, and expects to maintain its existing reinvestment rate. Atlantic has a capital structure composed 60% of equity and 40% of debt. Its cost of equity is 12% and it has a pretax cost of borrowing of 8%. The firm currently faces a tax rate of 40%.

a. Estimate the value of the firm.

b. Assume now that Atlantic Cruise Lines will move its headquarters to the Cayman Islands. If its tax rate drops to 0% as a consequence, estimate the effect on value of the shift.

3. Everlast Batteries Inc. has hired you as a consultant. The firm had after-tax operating earnings in 1998 of $180 million and net income of $100 million, and it paid a dividend of $50 million. The book value of equity at the end of 1998 was $1.25 billion, and the book value of debt was $350 million. The firm raised $50 million of new debt during 1998. The market value of equity at the end of 1998 was twice the book value of equity, and the market value of debt was the same as the book value of debt. The firm has a cost of equity of 12% and an after-tax cost of debt of 5%.

a. Estimate the return on capital earned by Everlast Batteries.

b. Estimate the cost of capital earned by Everlast Batteries.

c. Estimate the economic value added by Everlast Batteries.

4. You have estimated the value per share for Littlefield Inc., a transportation company, under three scenarios: $5/share under the worst-case scenario, $30/share under the best-case scenario, and $18/share under the most likely scenario. If the stock is trading at $15, would you buy the stock? Why or why not?