Question 1 Fancy Packaging, Inc. (FPI) is a manufacturer of custom packaging products. FPI is considering introducing a new line of packaging, the Toledo series. FPI engineers expect the technology used in these products to become obsolete after four years. During the next four years, however, annual cash flows are expected to be $18 million per year. The product line will require a $24 million investment in new equipment, which is due immediately (1/1/10). FPI’s market-value balance sheet indicates that the company has currently $20 million in cash, $600 million in other assets, $320 million in debt, and $300 in equity. FPI intends to maintain a constant debt-to-value ratio for the foreseeable future. At this debt-to-value ratio, the company’s cost of debt capital is 6% and its cost of equity capital is 10%. The tax rate is 40%. 1) Should FPI undertake the Toledo project? Derive the solution using both the WACC and the APV method! (Your solution should be the same under either method.) Hint: You can proceed the same way as we did for Example 4-2 (the candy example). As for the APV solution, you should proceed as in the uploaded APV solution to Example 4-2 (pp. 37-39). The solution method is exactly the same. The cash flows are -24 million (1/1/10) and then 18 million on 12/31/10, 12/31/11, 12/31/12, and 12/31/13, respectively. Lastly, to compute the optimal debt-to-value ratio (D/[D+E]), you should use net debt (debt minus cash) for D. b) How much debt does FPI need to issue today? How much debt will it have in 1, 2, and 3 years from now? What is the present value of the interest tax shields? Again, you should proceed as in the uploaded APV solution to Example 4-2. (p. 41). Question 2 The common stock and debt of Northern Sludge are valued at $50 million and $30 million, respectively. Investors currently require (or equivalently, expect) a 16% return on the firm’s common stock and 8% on its debt. a) What is Northern Sludge’s expected return on assets? b) Suppose Northern Sludge issues $10 million of common stock and uses the proceeds to retire (i.e., buy back) debt. Thus, the market value of the debt goes down to $20 million. Assume MM Proposition I holds, so the market value of the firm overall remains unchanged. What is the effect of this debt buyback on the expected return of Northern Sludge’s common stock? Question 3 The SI Corporation operates in an economy with no taxes and perfect capital markets, i.e., it operates in a perfect Modigliani-Miller world. It has an expected operating income of $100 million per year forever. The expected payment to debtholders is $40 million per year forever and the expected payment to equity holders is $60 million per year forever. The expected rate of return on the firm’s assets is 12%. The rate of return on the market portfolio (i.e., rM) is 16% and the risk-free rate (i.e., rF) is 6%. The firm’s debt has currently a beta of 0.4. a) What is the (i) total firm value? (ii) value of the firm’s debt? (iii) value of the firm’s equity? [Hint: you first need to compute the expected rate of return on the firm’s debt!] b) The firm has decided to change its debt/equity ratio by issuing equity and using the funds to repurchase debt. After this change in capital structure, the firm’s remaining debt will be risk-free and the expected amount paid to debtholders will be $20 million per year forever. After the change in capital structure, what is the (i) total firm value? (ii) value of the firm’s debt? (iii) value of the firm’s equity?
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