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FIN5FMA – FINANCIAL MANAGEMENT Question 1 Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered

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FIN5FMA – FINANCIAL MANAGEMENT

Question 1

Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies’ economists agree that the probability of the continuation of the current expansion is 80 percent for the next year, and the probability of recession is 20 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $2.7 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.1 million. Steinberg’s debt obligation requires firm to pay $900,000 at the end of the year. Dietrich’s debt obligation requires the firm to pay $1.2 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 13 percent.

a. What is the value today of Steinberg’s debt and equity? What about that for Dietrich?

b. Steinberg’s CEO recently stated that Steinberg’s value should be higher than Dietrich’s because the firm has less debt and therefore less bankruptcy risk. Do you agree or disagree with this statement?

Question 2) Fountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for coming year. The managers of Fountain must choose between two mutually exclusive projects. Assume that the project Fountain chooses will be the firm’s only activity and that the firm will close one year from today. Fountain is obligated to make a $3,500 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects:

Economy	Probability	Low-Volatility project payoff	High-volatility project payoff
Bad	.50	$3,500	$2,900
Good	.50	3,700	4,300

 

 a. What is the expected value of the firm if the low-volatility project is undertaken? What if the high-volatility project is undertaken? Which of the two strategies maximises the expected value of the firm?

b. What is the expected value of the firm’s equity if the low-volatility project is undertaken? What is it if the high-volatility project is undertaken?

c. Which project would Fountain’s stockholders prefer? Explain.

d. Suppose bondholders are fully aware that stockholders might choose to maximise equity value rather than total firm value and opt for the high-volatility project. To minimise this agency cost, the firm’s bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if Fountain chooses to take on the highvolatility project. What payment to bondholders would make stockholders indifferent between the two projects?

Question 3) When personal taxes on interest income and bankruptcy costs are considered, the general expression for the value of a levered firm in a world in which the tax rate on equity distribution equals zero is:

VL = VU + {1- [(1-tC)/(1-tB)]} x B – C(B)

Where

VL = The value of a levered firm

VU = The value of an unlevered firm

B = The value of the firm’s debt

tC = The tax rate on corporate income

tB = the personal tax rate on interest income

C(B) = The present value of the costs of financial distress

a. In their no-tax model, what do Modigliani and Miller assume about tC, tB and C(B)? What do these assumptions imply about a firm’s optimal debt-equity ratio?

b. In their model with corporate taxes, what do Modigliani and Miller assume about tC, tB and C(B)? What do these assumptions imply about a firm’s optimal debt-equity ratio?

c. Consider an all equity firm that is certain to be able to use interest deduction to reduce its corporate tax bill. If the corporate tax is 34 percent, the personal tax rate on interest income is 20 percent, and there are no costs of financial distress, by how much will the value of the firm change if it issues $1 million in debt and uses the proceeds to repurchase equity?

d. Consider another all equity firm that does not pay taxes due to large tax loss carry forwards from previous years. The personal tax rate on interest income is 20 percent, and there are no costs of financial distress. What would be the change in the value of this firm from adding $1 of perpetual debt rather than of $1 equity?

Question 4) Sophie Pharmaceuticals Ltd has 9.6 million ordinary shares on issue. The current market price is $12.50 per share. However, the company manager knows that the results of some recent drug tests have been remarkably encouraging, so that the ‘true’ value of the shares is $13. Unfortunately, because of confidential patent issues, Sophie Pharmaceuticals cannot yet announce these test results. In addition, Sophie Pharmaceuticals has a property investment opportunity that requires an outlay of $15 million and has a net present value of $2.5 million. At present, Sophie Pharmaceuticals has little spare cash or marketable assets, so if this investment is to be made it will need to be financed from external sources. The existence of this opportunity is not known to outsiders and is not reflected in the current share price. Should Sophie Pharmaceuticals make the new investment? If so, should the investment be made before or after the share market learns the true value of the company’s existing assets? Should the investment be financed by issuing new shares or by issuing new debt?