FIN 602 Corporate Finance 1 Mid-Term Section-B 3/5, 5/7

FIN 602 Corporate Finance
1st Mid- Term
Section-B 3/5, 5/7
1. What are the three key activities of financial manager? Related to the firms balance sheet?
2. What happens to the cost of debt and equity when the financial leverage increase and why?
3. MM’s proposition 1 in a world of no taxes implies that an issue of debt increases expected
earnings per share and leads to an offsetting fall in the price- earnings ratio. Explain?
4. Under what circumstance, would a firm like to favor risky project with negative NPVs?
5. What does free cash flow hypothesis has implication for capital structure?
6. It is empirically observed that, “when a firm issues new secondary equity to the market the share
price of the firm fails” How can you explain the above phenomenon?
7. Can you infer the characteteristies of the firms based on its consecutive OCF and FCF?
Section-C
1. Calculate the PV of interest- tax shield on Tk. 100,000, two years loan at 9 per cent interest
rate, in a perfect capital market, if the firm is in the 40 per cent tax bracket.
2. At the end of 2012 the long term debt to market value of equity ratio of prime textile was
5%.
1) Suppose that prime textile has decided to issue Tk. 50 million of long term debt. The goal
is to roll over this debt (i.e. replace it by another Tk. 50 million issue) when it matures.
Suppose that prime textile’ s marginal corporate tax rate is 40% , that the effective
personal tax rate on equity income is 0% and that effective personal tax rate on debt
income is 25% . What is the gain from adding Tk. 50 million of debt to the current capital
structure assuming that tax are the sole determine of the gain from leverage?
2) If only taxes are relevant, what would apex spinning’s market value of equity have been
at the end of 2012 if it were all equity finance. Assume a 40% corporate tax rate and
personal tax rates as listed in part
3) The market value of Apex Spinning’s equity was Tk. 100 million at the end of 2012.
3. Green Manufacturing Inc. plans to announce that it will issue Tk. 20 million of perpetual debt
and use the proceeds to repurchase common stock. The bond will have a 6-percent annual
coupon rate. Green is currently an all equity firm with 5,000,000 shares of common stock
outstanding. After the sale of the bond, Green will maintain the new capital structure
indefinitely, Green currently generates annual pretax earnings of Tk. 25 million. This levels
of earnings is expected to remain constant in perpetuity. Green in subject to a corporate tax
rate of 40 per cent and the return on the firm’s assets is currently 15%
a) What is the value of Green Manufacturing Inc. before the announcement of the debt
issue? What is the market value per share of the firm equity?
b) Construct Green’s market- value balance sheet after the restructuring?
c) What is the required return on Green equity after the restructuring?
d) Calculate the value of Green Manufacturing Inc. using the Rwacc?
SUMMARY AND CONCLUSIONS 1
Question-3: In a world of no taxes, the famous Proposition I of Modigliani and

Miller proves that the value of the firm is unaffected by the debt-to-equity ratio.
In other words, a firm’s capital structure is a matter of indifference in that world.
The authors obtain their results by showing that either a high or a low corporate
ratio of debt to equity can be offset by homemade leverage. The result hinges on
the assumption that individuals can borrow at the same rate as corporations, an
assumption we believe to be quite plausible.
Q.5: Free Cash Flow
The hypothesis has important implications for capital structure. Since dividends
leave the firm, they reduce free cash flow. Thus, according to the free cash flow
hypothesis, an increase in dividends should benefit the stockholders by reducing
the ability of managers to pursue wasteful activities. Furthermore, since interest
and principal also leave the firm, debt reduces free cash flow as well. In fact,
interest and principal should have a greater effect than dividends have on the free-
spending ways of managers, because bankruptcy will occur if the firm is unable to
make future debt payments. By contrast, a future dividend reduction will cause
fewer problems to the managers, since the firm has no legal obligation to pay
dividends. Because of this, the free cash flow hypothesis argues that a shift from
equity to debt will boost firm value. In summary, the free cash flow hypothesis
provides still another reason for firms to issue debt. We previously discussed the
cost of equity; new equity dilutes the holdings of managers with equity interests,
increasing their motive to waste corporate resources. We now state that debt
reduces free cash flow, because the firm must make interest and principal
payments. The free cash flow hypothesis implies that debt reduces the opportunity
for managers to waste resources.
Q.NO:
Q.1 and 3 Ans. Math

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FIN 602 Corporate Finance

1st Mid- Term

Section-B 3/5, 5/7

Question-3: In a world of no taxes, the famous Proposition I of Modigliani and

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