Corporate Finance – Assignment 8 Problems

Assignment 8

Problem 1

 

Lowell Inc. has no debt and its financial position is given by the

following data:

 

Assets

(book = market) $3,000,000

 

EBIT $500,000

 

Cost of equity (Ks) 10%

 

Stock price (P0) $15

 

Shares outstanding n0 200,000

 

Tax rate T 40%

  

The firm is considering selling bonds and simultaneously

 

repurchasing some of its stock. It if moves to capital structure

 

with 30 percent debt based on market values, its cost of equity,

 

Ks, will increase to 11 percent to reflect the increased risk.

 

Bonds can be sold at a cost (Kd) of 7 percent. Lowell Inc. is a

 

no-growth firm. Hence, all its earnings are paid out as

 

dividends, and earnings are exceptionally constant over time.

  a. 

A. What would be the new WACC?

B. What effect would this use of leverage have on the value of the
firm (Va)?

C.What would be Lowell Inc.’s stock price?

D.
What happens to the firm’s earnings per share after the
recapitalization?

  

Problem 2

Mass Inc. is trying to estimate its optimal capital

 

structure. Right now, Mass Inc. has a capital structure

 

that consists of 50 percent debt and 50 percent equity,

 

based on market values. (Its D/S ratio is 1.00) The riskfree

 

rate is 6 percent and the market risk premium, K

M –

 K

RF, is 5 percent. Currently the company’s cost of equity,

 

which is based on the CAPM, is 12 percent and its tax rate

 

is 40 percent. What would be Mass Inc.’s estimated cost of

equity if it were to change its capital structure to 60 percent debt and 40 percent equity?

Problem 3

23,104 32,562

Cost of goods sold

 

8,195 14,176

BALANCE SHEET COCA-COLA PEPSI

Assets

Cash and Cash Equivalents 4,701 1,716

Short-term Investments 66 3,166

Accounts Receivables 2,281 3,261

Inventory 1,424 1,693

Other Current Assets 1,778 618

Total Current Assets

10,250 10,454

Total Assets

29,427 31,727

Financed by: COCA-COLA PEPSI

Accounts Payable 5,290 5,357

Short-term debt 4,546 2,889

Other Current Liabilities 0 1,160

Total Current Liabilities

9,836 9,406

Problem 4

In-tech Corporation’s sales and purchases for the last three

months are as following:

Sales ($) Purchases ($)

October 100,000 80,000

November 90,000 100,000

December 120,000 75,000

For the next three months, it estimates sales and purchases

to be as following:

Sales ($) Purchases ($)

January 90,000 70,000

February 80,000 70,000

March 80,000 70,000

It pays 40 percent of purchases in cash and gets a 4

percent discount. Another 40 percent of purchases are paid

the next month, and the final 20 percent of purchases are

paid in the second month after the purchase (for example,

40 percent of October purchases are paid in October, 40

percent October purchases are paid in November, and 20

percent October purchases are paid in December). Half of

the sales are made in cash, and the balance is collected

the next month. Cash sales are given a two percent

discount, and five percent of credit sales end up as bad

debt. The monthly operating expenses for In-tech

Corporation’s are $10,000. In-tech expects to sell one of

its machinery in March for $25,000. It will buy the

replacement in April for $50,000. The cash balance as on

December 31 was $50,000. In-tech has a target cash balance

of $50,000. Prepare a monthly cash budget for the next

three months.