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Exam 17: Dynamic Capital Structures and Corporate Valuation

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Question 31

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NorthWest Water (NWW) Five years ago, NorthWest Water (NWW) issued $50,000,000 face value of 30-year bonds carrying a 14% (annual payment) coupon. NWW is now considering refunding these bonds. It has been amortizing $3 million of flotation costs on these bonds over their 30-year life. The company could sell a new issue of 25-year bonds at an annual interest rate of 11.67% in today's market. A call premium of 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million. NWW's marginal tax rate is 40%. The new bonds would be issued when the old bonds are called. -Refer to the data for NorthWest Water (NWW) . The amortization of flotation costs reduces taxes and thus provides an annual cash flow. What will the net increase or decrease in the annual flotation cost tax savings be if refunding takes place?

A) $6,480
B) $7,200
C) $8,000
D) $8,800
E) $9,680

F) A) and B)
G) A) and C)

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Question 32

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10 years ago, the City of Melrose issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-exempt muni bonds. The bonds had 10 years of call protection, but now the bonds can be called if the city chooses to do so. The call premium would be 6% of the face amount. New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2% of the amount of bonds sold. What is the net present value of the refundingσ Note that cities pay no income taxes, hence taxes are not relevant.

A) $453,443
B) $476,115
C) $499,921
D) $524,917
E) $551,163

F) A) and B)
G) A) and C)

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Question 33

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According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

Alpha Manufacturing has the following financial information for the current year and projected for next year. Calculate its projected free cash flow to equity. $\begin{array} { l r r } & { \text { Current } } \\& \text { year } & \text { Prajected } \\\text { EBIT } & 1,500 & 1,800 \\\text { Operating a5sets } & 3,000 & 3,400 \\\text { Operating liabilities } & 200 & 220 \\\text { Tetal debt } & 1,500 & 1,800 \\\text { Interest rate an debt } & 6 \% & 6 \% \\\text { Trax rate } & 25 \% & 25 \%\end{array}$  

Zeta Technologies has the following projections. It has no non-operating assets. Calculate Zeta's intrinsic value of equity using the FCFE model. $\begin{array}{l}\begin{array} { l } \\ \\\text { FCFE }\\\text { Total debt }\\\text {Interest rate on debt }\\\text {Tax rate}\\\text { Long-term growth rate}\\\text { Required return on equity }\\\end{array}\begin{array} { l } \text { Cunent }\\\text { Year } & \text { Year 1 } & \text { Year 1 } & \text { Year 3 } \\NA& 1,000 & 1,200 & 1,248 \\3,000 & 3,900 & 4,290 & 4,462 \\6 \% & 6 \% & 6 \% & 6 \% \\25 \% & 25 \% & 25 \% & 25 \%\\4\%\\9\%\end{array}\end{array}$    

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

If the firm uses the after-tax cost of new debt as the discount rate when analyzing a refunding decision, and if the NPV of refunding is positive, then the value of the firm will be maximized if it immediately calls the outstanding debt and replaces it with an issue that has a lower coupon rate.

Kitto Electronics Data Kitto Electronics has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets. Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%. -Refer to data for Kitto Electronics. According to the compressed adjusted present value model, what is Kitto's unlevered value?

MM showed that in a world without taxes, a firm's value is not affected by its capital structure.

The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt.