Subject: Business    / Finance
Question
10. Fun Toy Corporation estimates that there is 25% chance of a recession economy next
year, a 50% chance of a normal economy next year, and a 25% chance of a boom
economy next year. The corporation will exist until the end of next year and then it will
cease to exist. Fun has $80 of debt that must be repaid next year. Assume a 0% discount
rate for all cash flows (in other words, there is no discounting).
(a) [Fun Toy has a low risk project that yields a cash flow of $70 in a recession, $100 in a
normal economy, and $130 in a boom. If Fun Toy chooses this low risk project:
(i) what is the value of Fun Toy’s debt? (ii) what is the value of Fun Toy’s equity? (b) Fun Toy has a high risk project that yields a cash flow of $30 in a recession, $100 in a normal economy, and $160 in a boom. If Fun Toy chooses this high risk project: (i) what is the value of Fun Toy’s debt? (ii) what is the value of Fun Toy’s equity? (c) Which project will Fun Toy choose? Given your answers to (a) and (b), when Fun Toy sells the bonds would it like to include a covenant that would prohibit it from taking the high­risk project? Explain your answer.

11. A firm is currently an all equity firm with 1 million shares outstanding and a stock price of $10. The firm is contemplating selling $1 million in bonds and using the proceeds to repurchase shares. The current expected return on the firm’s stock is 20% and the bonds would offer investors a 10% expected return. In all of the scenarios below, the combined financial distress and agency costs associated with debt financing are equal to 2% of the value of the debt issued. (a) If the corporate tax rate is 40% and personal tax rates on income and capital gains are 0, what will the value of the firm be after the repurchase assuming the firm intends to maintain the $1 million in debt forever (i.e., in perpetuity). (b) If the corporate tax rate is 40%, the effective personal tax rate on equity income (TE) is equal to 0, and the tax rate on interest income (TD) is equal to 40%, what will the value of the firm be after the repurchase assuming the firm intends to maintain the $1 million in debt forever (i.e., in perpetuity).

12. Wolverine Corp. currently has $5,000,000 in equity outstanding and $1,000,000 in debt outstanding. The firm currently has 500,000 shares of common stock outstanding. The firm is contemplating issuing an additional $1,000,000 in debt and using the proceeds to repurchase shares. The corporate tax rate is 40%, the effective personal tax rate on equity income is 10%, and the effective personal tax rate on interest income is 20%.
What will the firm’s stock price be the moment after the firm announces its refinancing plan? (b) Calculate the total market value of the firm’s (i) debt and (ii) equity immediately after the refinancing plan is announced (but before it is actually executed). (c) Calculate the total market value of the firm’s (i) debt and (ii) equity after the bond issue and equity repurchase are completed.

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