This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Consider a project with free cash flows in one year of $145,000 or
$195,000, with each outcome being equally likely. The initialinvestment required for the project is $120,000 and the project’s cost ofcapital is 30%. The risk-free interest rate is 12%.
2. Suppose that to raise the funds for the initial investment, theproject is sold to investors as an all-equity firm. The equity holders
will receive the cash flows of the project in one year. What is theinitial market value of the unlevered equity?
Consider a project with free cash flows in one year of $145,000 or
$195,000, with each outcome being equally likely. The initialinvestment required for the project is $120,000 and the project’s cost ofcapital is 30%. The risk-free interest rate is 12%.
2. Suppose that to raise the funds for the initial investment, theproject is sold to investors as an all-equity firm. The equity holders
will receive the cash flows of the project in one year. What is theinitial market value of the unlevered equity?
Consider a project with free cash flows in one year of $145,000 or
$195,000, with each outcome being equally likely. The initialinvestment required for the project is $120,000 and the project’s cost of
capital is 30%. The risk-free interest rate is 12%.
3. Suppose that initial $120,000 is instead raised by borrowing at therisk-free rate. What are the cash flows of the levered equity, and
what is its initial value according to MM? equity value is total firm value minus debt value value of debt next period is debt value×r f equity cash flow is the difference between total cash flow and cash
to debt.
Value at year 0 CF Strong CF WeakDebt 120,000 134,400 134,400Equity 10,769 60,600 10,600
In mid-2012, AOL Inc. had $200 million in risk-free debt, total equity
capitalization of $3.3 billion, and an equity beta of 0.92. Included inAOL’s assets was $1.6 billion in cash and risk-free securities. Assumethat the risk-free rate of interest is 2.9% and the market risk premium
In mid-2012, AOL Inc. had $200 million in risk-free debt, total equity
capitalization of $3.3 billion, and an equity beta of 0.92. Included inAOL’s assets was $1.6 billion in cash and risk-free securities. Assumethat the risk-free rate of interest is 2.9% and the market risk premium
In mid-2012, AOL Inc. had $200 million in risk-free debt, total equity
capitalization of $3.3 billion, and an equity beta of 0.92. Included inAOL’s assets was $1.6 billion in cash and risk-free securities. Assumethat the risk-free rate of interest is 2.9% and the market risk premium
In mid-2012, AOL Inc. had $200 million in risk-free debt, total equity
capitalization of $3.3 billion, and an equity beta of 0.92. Included inAOL’s assets was $1.6 billion in cash and risk-free securities. Assumethat the risk-free rate of interest is 2.9% and the market risk premium
Question 6Suppose Goodyear Tire and Rubber Company is considering divestingone of its manufacturing plants. The plant is expected to generate free
cash flows of $2 million per year, growing at a rate of 3% per year.Goodyear has an equity cost of capital of 9%, a debt cost of capital of7.5%, a marginal corporate tax rate of 40%, and a debt-equity ratio of
3.1. If the plant has average risk and Goodyear plans to maintain aconstant debt-equity ratio, what after-tax amount must it receive for theplant for the divestiture to be profitable?
Question 6Suppose Goodyear Tire and Rubber Company is considering divestingone of its manufacturing plants. The plant is expected to generate free
cash flows of $2 million per year, growing at a rate of 3% per year.Goodyear has an equity cost of capital of 9%, a debt cost of capital of7.5%, a marginal corporate tax rate of 40%, and a debt-equity ratio of
3.1. If the plant has average risk and Goodyear plans to maintain aconstant debt-equity ratio, what after-tax amount must it receive for theplant for the divestiture to be profitable?
r WACC = E
E + D r E +
D
E + D r D (1 − τ C )
=
1
1 + 3.1 × 0.09 +
3.1
1 + 3.1 × 0.075× (1 − 0.4) = 0.056
V L = CF
r WACC − g =
2
0.056− 0.03 = 76.9 million
So the divestiture is profitable only if Goodyear receives more than
$76.9 million after tax. UGBA 103 – Introduction to Finance 14 / 28
Acort Industries has 20 million shares outstanding and a current share
price of $30 per share. It also has a long-term debt outstanding. Thisdebt is risk free, is four years away from maturity, has an annualcoupon rate of 5%, and has a $125 million face value. The first of the
remaining coupon payments will be due in exactly one year. Theriskless interest rates for all maturities are constant at 3%. Acort has
EBIT of $115 million, which is expected to remain constant each year.New capital expenditures are expected to equal depreciation andequal $22 million per year, while no changes to net working capital are
expected in the future. The corporate tax rate is 38%, and Acort is
expected to keep its debt-equity ratio constant in the future (by eitherissuing additional new debt or buying back some debt as time goeson).
1. Based on this information, estimate Acort’s WACC.
Question 10Suppose a stock is currently trading for $65, and in one period willeither go up by 25% or fall by 15%. If the one-period risk-free rate is
4.0%, what is the price of a European put option that expires in oneperiod and has an exercise price of $65? Suppose the option actuallysold in the market for $8. Describe a trading strategy that yields
Question 10Suppose a stock is currently trading for $65, and in one period willeither go up by 25% or fall by 15%. If the one-period risk-free rate is
4.0%, what is the price of a European put option that expires in oneperiod and has an exercise price of $65? Suppose the option actuallysold in the market for $8. Describe a trading strategy that yields
Question 11Suppose the current price of Narver Network systems stock $55 pershare. In each of the next two years, the stock price will either increase
by 25% or decrease by 15%. The 6% one-year risk-free rate of interestwill remain constant. Suppose the put option with a strike price of $60actually sold today for $3.87. You do not know what the option will
trade for next period. Describe a trading strategy that will yieldarbitrage profits.
Question 11Suppose the current price of Narver Network systems stock $55 pershare. In each of the next two years, the stock price will either increase
by 25% or decrease by 15%. The 6% one-year risk-free rate of interestwill remain constant. Suppose the put option with a strike price of $60actually sold today for $3.87. You do not know what the option will
trade for next period. Describe a trading strategy that will yieldarbitrage profits.
Suppose the current price of Narver Network systems stock $55 per
share. In each of the next two years, the stock price will either increaseby 25% or decrease by 15%. The 6% one-year risk-free rate of interestwill remain constant. Suppose the put option with a strike price of $60
actually sold today for $3.87. You do not know what the option willtrade for next period. Describe a trading strategy that will yield
Suppose the current price of Narver Network systems stock $55 per
share. In each of the next two years, the stock price will either increaseby 25% or decrease by 15%. The 6% one-year risk-free rate of interestwill remain constant. Suppose the put option with a strike price of $60
actually sold today for $3.87. You do not know what the option willtrade for next period. Describe a trading strategy that will yield
arbitrage profits.Box 3:
m = 68.75− 46.75
0.7 − 9.85 = −2.4
P = 1
−2.4
55−46.75 + 2.4 × 9.85
1 + 0.06
= 4.76
If the put is selling for $3.87 it is underpriced. You should purchase theput and the stock, and borrow $27.67 at the risk-free rate.