Tutorial Assignment 2

FIN3101A Corporate Finance

(Topics: NPV and Capital Structure)
Instructor: Allaudeen Hameed
Teaching Assistant: Tan Chek Ann

This tutorial assignment should be done in groups assigned. There is no submission required.
We will discuss some of the questions during the scheduled time.

1. ABC Inc. is considering repurchasing part of its common stock by issuing corporate debt.
As a result, the firm’s debt-to-equity ratio is expected to rise from 40% to 60%. The firm
currently has $5.4 million worth of debt outstanding. The cost of this debt is 10% per annum.
ABC’s EBIT is expected to be $2.48 million per year in perpetuity. ABC pays no taxes.
Assume M&M’s perfect world.
a. What is the market value of the firm before and after the repurchase announcement?
b. What is the expected return on the firm’s equity (ROE) before the announcement of the
stock repurchase plan?
c. What is the expected ROE of an otherwise identical all-equity firm?
d. What is the expected ROE after the announcement of the stock repurchase plan?

2. NHP invested $100 million in a new production line which will generate after-tax operating
cash flow of $40 million at the end of each of the next 5 years. There is no net working
capital investment required. The new line will wear out and will have zero salvage value.
NHP’s cost of capital is 10% and its corporate tax rate is 30%. Note that after-tax operating
cash flow is equal to net operating profit after-tax (NOPAT) plus depreciation.
a. Find the NPV of the project.
b. Find the PV of the project’s EVAs under each of the depreciation schedules below:
(i) Straight-line full depreciation over 5 years;
(ii) Annual depreciation of 40%, 30%, 20%, 10% and 0% over 5 years;
(iii) Annual depreciation of 25%.
HINT: To compute the annual EVAs, use the definition EVA = NOPAT – (Capital
Employed × Cost of Capital), where Capital Employed is the value of the asset at the
start of each year. NOPAT = Net Operating Profit After Tax.
c. What is the relationship between the NPV and the PV of EVAs of a project?

3. The manager of Sigma Corporation estimates that a good economic condition and a bad
economic condition are equally likely for the coming year. The manager, who works in the
shareholders’ interests, must choose between two mutually exclusive projects. Assume
that the firm will close one year from now. Sigma Corporation is obligated to make a $3,000
payment to its bondholders at the end of the year. The two projects have the same
systematic risk but different volatilities. Information pertaining to the payoffs of the two
projects is summarized below:

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 Volatility Good State Bad State
Project A High $3,500 $2,500
Project B Low $3,200 $3,000

a. What is the expected value of the firm if the low-volatility project is undertaken? What
if the high-volatility project is undertaken? Which of the two projects maximizes the
expected value of the firm?
b. What is the expected value of the firm’s equity if the low-volatility project is undertaken?
What is it if the high-volatility project is undertaken? Which project would Sigma’s
shareholders prefer?
c. Suppose the bondholders are fully aware that the manager might choose to maximize
equity value rather than total firm value and opt for the high-volatility project. To alleviate
this agency problem, the firm’s bondholders decide to use a bond covenant to stipulate
that the bondholders can demand a higher payment if the firm chooses to take on the
high-volatility project. What additional payment to the bondholders would make the
shareholders indifferent between the two projects?

4. Artric Corporation is trying to determine its optimal capital structure, which only consists of
debt and common equity. Currently, its debt-to-asset ratio is 20%, cost of equity 8%, and
before-tax cost of debt 4%. The firm’s marginal tax rate is 30%.
a. What is the firm’s current WACC?
b. Assume that the cost of debt remains unchanged at 4% at all debt levels. Assume M&M
world with corporate taxes holds.
(i) What will be the firm’s cost of equity and WACC if it changes its debt-to-asset
ratio to 0.4, 0.6, and 0.8, respectively?
(ii) From part (i) above, which is the best capital structure that Artric should adopt?
c. Artric’s management believes that it may not be realistic to expect its cost of debt to
remain constant as its debt level changes. The firm’s CFO has consulted some
investment bankers, and based on the discussions, she creates the following table
showing the firm’s estimated cost of debt at different debt levels:

Debt-to-Asset Ratio Bond Rating Before-Tax Cost of Debt

0.4 BB 5%
0.6 C 7%
0.8 D 9%

Furthermore, the CFO feels that the cost of equity would change according to the
change in its equity beta, which will be determined by the following equation:

βL =βU[1 + (1 – T)(B/S)] where βL: Equity beta at a specific debt level

βU: Equity beta if the firm has no debt
T: Corporate tax rate
B/S: Debt-to-equity ratio

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 Artric uses CAPM to estimate its cost of equity. The risk-free rate is 2% and the market
risk premium is 6%. The firm’s unlevered beta is 0.9.
(i) What will be the firm’s cost of equity and WACC if it changes its debt-to-asset
ratio to 0.4, 06, and 0.8, respectively?
(ii) Based on part (i) above, what is the optimal capital structure for Artric?

5. Use Yahoo Finance to locate the annual financial statements of McDonald’s Corporation
(ticker: MCD) as of December 30, 2022. Assume M&M world with corporate taxes.
a. Estimate the company’s market value of equity and approximate the market value of
its debt by the book value of its long-term debt.
b. Compute the debt-to-equity ratio of MCD.
c. Calculate the company’s marginal tax rate for FY 2022 by dividing its income tax
expense by its income before tax. How does it compare to the U.S. corporate tax rate
of 21%.
d. Find the beta of MCD. Then compute its unlevered beta.
e. You obtained the following data on MCD’s long-term bond. MCD issued a USD 500
million bond issued in 2020 (Moody’s rating is Baa1) with a coupon of 3.8% maturing
in April 2029 and recently traded at yield-to-maturity of 4.2%. What is the cost of debt
of MCD?
f. If the cost of unlevered equity for MCD is 7%, what is the cost of its levered equity?
g. With the above information, compute the current WACC of MCD.
h. Assume that MCD is considering issuing $50 billion of permanent new debt and use
the proceeds to repurchase shares. Assume corporate tax rate of 21%.
(i) Determine the present value of the tax shield of the new debt.
(ii) What is the new market value of equity after the new debt issuance?
(iii) Does the debt increase and the stock repurchase appear to be a good idea?

6. The Everest Company has 12 million shares trading at $6.50 each. It announced a rights
issue of 1 new share for every 6 shares held at $5 a share, and explained that the funds
raised will be invested in a project with NPV of $4.5 million.
a) On announcement of the positive NPV project, how would the share price
respond?
b) What was the total amount of new money raised?
c) What was the value of a right?
d) What was the ex-rights price?
e) How far could the share price fall before shareholders would be unwilling to take
up their rights?

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7. Firm X and Y are identical firms with the same assets and cash flows, except for their
capital structure. Assume M&M perfect world holds. To make it simple, assume that each
firm’s asset will generate net cash flow next year (one year from now) and the firm will
cease to exist after that. The cash flow will depend on whether the economy is strong or
weak. In a strong economy the cash flow is $1400 and in a weak economy the cash flow
is $900. Firm X is unlevered and its equity has a market value of $990. Firm Y has borrowed
$500 at 5% and its equity has a market value of $510.

The above information is summarized below:

Cash Flow in Year 1

Market
Value Strong Weak
Today Economy Economy

Firm X - Equity 990 1400 900

Firm Y - Debt 500 525 525

Firm Y- Equity 510 875 375

Does M&M Proposition I hold? What arbitrage opportunity is available using homemade
leverage?