THE UNIVERSITY OF HONG KONG

FACULTY OF BUSINESS AND ECONOMICS

FINA1003/1310A/B/C Corporate Finance
FIRST SEMESTER, 2014-2015

Homework Assignment 4
Due Date: 5th December, 2013 (Friday) by 6pm
Please drop your assignment into Clives mailbox A34 at 9/F KKL Building directly
Note:

The homework assignment is group based.

Each group should have 2-5 members. Your group-mate could come from different
tutorial sessions and different subclasses (subclass A, B or C). Once the group is
formed, no change is allowed. End of term peer evaluation (focus on willingness and
efforts to work in the team) will be conducted.
Please attach the Homework Cover Page when submitting your
assignment. Round off your answer to 4 decimal points. No late homework will be
accepted.

Question 1 (Bid Price: 15 points)

Consider a project to supply 100 million camping tents per year to the victims of
typhoon Haiyan in the Philippines for next five years. You have an idle parcel of land
in Cebu available that cost $2,400,000 five years ago; if the land were sold today, it
would net you $2,700,000 after-tax. The land can be sold for $3,200,000 after taxes in
five years.
(1)

You will need to install $4.1 million in new manufacturing plant and
equipment to actually produce the camping tents; this plant and equipment
will be depreciated straight-line to zero over the project's five-year life. The
equipment can be sold for $540,000 at the end of the project.

(2)

You will also need $600,000 in initial net working capital for the project, and
an additional investment of $50,000 in every year thereafter. Your production
costs are 0.5 cents per tent, and you have fixed costs of $950,000 per year.

If your tax rate is 34% and your required return on this project is 12%, what bid price
should you submit on the contract?

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Question 2 (Financial Breakeven: 10 points)

Clive Inc. has been busy analyzing a new product. Thus far, management has
determined that an OCF of $218,200 will result in a zero net present value for the
project, which is the minimum requirement for project acceptance. The fixed costs are
$329,000 and the contribution margin per unit is $216.40. The company feels that it
can realistically capture 2.5% of the 110,000 unit market for this product. The tax rate
is 34% and the required rate of return is 11%.
Should the company develop the new product? Why or why not?

Question 3 (WACC: 15 points)

Firm As capital structure contains 20% debt and 80% equity. Firm Bs capital
structure contains 50% debt and 50% equity. Both firms pay 7% annual interest on
their debt. The stock of Firm A has a beta of 1.0, and the stock of Firm B has a beta
of 1.375. The risk-free rate of interest equals 4%, and the expected return on the
market portfolio equals 12%.
(a)

Calculate the WACC for each firm assuming there are no taxes.

Recalculate the WACC figures assuming that the firms face a marginal tax rate of
34%.
(c) Explain how taking taxes into account in part (b) changes your answer found in
part (a).
(b)

Question 4 (WACC: 20 points)

Drink Well, is a leading producer of juice in the United States. The firm was founded
in 1980. Today (April, 2010), its juices are sold throughout the world. However, the
juice market has matured and Drink Well sales have been steadily decreasing.
Consequently, to increase sales, management is currently considering a potential new
product: a premium juice with less sugar. The new juice is designed to appeal to
middle-to-upper-income professionals. In market research samplings, it was judged
superior to various competing products. As the CFO, Clive must estimate the
company's cost of capital, analyze this project, and then present your findings to the
companys executive committee.
Suppose Clive has gathered the following information to estimate Drink Well (DW)
weighted average cost of capital.
2

FINA1003/1310A/B/C Homework Assignment 4________________________________________________

The bond quote on DW's long-term, semi-annual bond as reported in the financial
press is as follows:
Bonds

Coupon

Maturity

Current

Last Price

Net Change

109.5

+1/8

Yield

DW

8%

April, 2025

7.3

Quotes on DW's common and preferred stock are as follows:

Stock

Dividend

Yield %

PE

Close

Net Change

DW

2.40

4.0

7.5

60

+1/4

DWpf

1.78

6.8

---

26

-1/8

The one-year Treasury bill rate is 3%.

DW's tax rate is 35%
The firm's last dividend (D0) was $2.40. Some analysts anticipate a growth rate of
about 9% for the indefinite future. The company has 2 million shares outstanding.
The historical market risk premium is 10%. DW's beta, as measured by several
analysts who follow the stock, is 1.03.
The market value optimal target capital structure calls for 35% long-term debt, 5%
preferred stock, and 60% common equity.

What is your estimate of DW's required return on debt?

(b) What is the estimate of the required return on preferred stock?
(a)

(c)

What is DW's estimated required return on common equity, using the CAPM

approach?
(d) What is the dividend discount model estimate of DW's required return on common
equity?
(e) What is DWs weighted average cost of capital?

Question 5 (Value of Rights: 10 points)

Barstow Industrial Supply has decided to raise $27.52 million in additional funding
via a rights offering. The firm will issue one right for each share of stock outstanding.
The offering consists of a total of 860,000 new shares. The current market price of the
stock is $35. Currently, there are 5.16 million shares outstanding.

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What is the value of one right?

Question 6 (Value of Rights: 10 points)

Atlas Corporation wants to raise $4 million via a rights offering. The company
currently has 450,000 shares of common stock outstanding that sell for $40 per share.
Its underwriter has set a subscription price of $26 per share and will charge the
company a 7% spread on the subscription price. Assume that you currently own 7,200
shares of stock in the company and decide not to participate in the rights offering.
How much can you get for selling all of your rights?

Question 7 (Capital Structure: 10 points)

Tool Manufacturing has an expected EBIT of $64,000 in perpetuity and a tax rate of
35%. The firm has $95,000 in outstanding debt at an interest rate of 8.5%, and its
unlevered cost of capital is 15%.
What is the value of the firm according to M&M Proposition I with taxes?
(b) Should the company change its debtequity ratio if the goal is to maximize the
value of the firm? Explain.

(a)

Question 8 (Leverage and Firm Value: 15 points)

Zekeriya Art Gallery expects and EBIT of 10,000 every year forever. Zekeriya
currently has no debt, and its cost of equity is 17%. The firm can borrow at 10%. If
the corporate tax rate is 35%,
What is the value of the firm?
(b) What will the value of the firm be if Zekerita converts to 50% debt? To 100%
debt?
(c) Using the results in part (a) and (b), explain the relationship between leverage and
firms value.
(a)