FINC206

Tutorial 6 - Questions

Questions marked with a * will be covered in tutorial class. Remaining questions are for practice
purpose.

1*.
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 High-volatility
project payoff 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 high-volatility
project. What payment to bondholders would make stockholders indifferent between the two
projects?

2*.
Good Time Company is a regional chain department store. It will remain in business for one
more year. The probability of a boom year is 60 percent and the probability of a recession is 40
percent. It is projected that the company will generate a total cash flow of $185 million in a
boom year and $76 million in a recession. The company’s required debt payment at the end of
the year is $110 million. The market value of the company’s outstanding debt is $83 million.
The company pays no taxes.
 a. What payoff do bondholders expect to receive in the event of a recession?

b. What is the promised return on the company’s debt?

c. What is the expected return on the company’s debt?

3*. Personal Taxes, Bankruptcy Costs, and Firm Value

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 personal tax rate on equity
distribution equals zero is:

𝑉𝑉𝐿𝐿 = 𝑉𝑉𝑈𝑈 + {1 − [(1 − 𝑡𝑡𝐶𝐶)/(1 − 𝑡𝑡𝐵𝐵)]} × 𝐵𝐵 − 𝐶𝐶(𝐵𝐵)

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 deductions 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 adding $1 of perpetual equity?

4*. Personal Taxes, Bankruptcy Costs, and Firm Value

Overnight Publishing Company (OPC) has $2.5 million in excess cash. The firm plans to use
this cash either to retire all of its outstanding debt or to repurchase equity. The firm’s debt is
held by one institution that is willing to sell it back to OPC for $2.5 million. The institution
will not charge OPC any transaction costs. Once OPC becomes an all-equity firm, it will
remain unlevered forever. If OPC does not retire the debt, the company will use the $2.5
million in cash to buy back some of its stock on the open market. Repurchasing stock also
has no transaction costs. The company will generate $1,300,000 of annual earnings before
interest and taxes in perpetuity regardless of its capital structure. The firm immediately pays
out all earnings as dividends at the end of each year. OPC is subject to a corporate tax rate
of 35 percent, and the required rate of return on the firm’s unlevered equity is 20 percent.
The personal tax rate on the interest income is 25 percent, and there are no taxes on equity
distribution. Assume there are no bankruptcy costs.

a. What is the value of OPC if it chooses to retire all of its debt and become an unlevered firm?

b. What is the value of OPC if it decides to repurchase stock instead of retiring its debt?

c. Assume that expected bankruptcy costs have a present value of $400,000. How does this
influence OPC’s decision?

5. Information asymmetry and capital structure (Challenging)

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?

6.
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?

7. Data collection and analysis

Collect data to calculate the debt-to-equity ratio over the most recent 5 years for 3 NZ
firms. What can you say about the debt-to-equity ratio of each firm over time? Does it
remain fairly stable or change significantly over time?