McGill University

Faculty of Management
Corporate Finance (FINE 342)
Fall 2017

ASSIGNMENT 2

REMARKS:

This is a group assignment with a maximum of 5 students per group.

The problems are to be answered in the space provided for them on this booklet.

Clearly show your working and encircle the final answer.

This assignment is due by 11am on Monday, Dec 11, 2017.

Member 1 Name : _______________________________________________________

Student no.: ____________________________

Member 2 Name : _______________________________________________________

Student no.: ____________________________

Member 3 Name : _______________________________________________________

Student no.: ____________________________

Member 4 Name : _______________________________________________________

Student no.: ____________________________

Member 5 Name : _______________________________________________________

Student no.: ____________________________

Corporate Finance (FINE 342) Page 1 of 10 Assignment 2

PROBLEM 1 (15 POINTS)

The MUS Company is planning to put a manufacturing facility in place to build widgets. The systematic risk of
this project alone is 25% greater than they currently manage. The company has a target debt to value ratio of
35%. The beta of the assets currently managed is 0.8 and they face a 36% tax rate. The initial investment cost
is $4,200,000 and the expected cash flows after tax are $1,200,000 per year for 6 years. The risk-free rate is
5% and you believe the historical market risk premium of 8.5% is a reasonable estimate.

(a) What is the all equity value of the investment? (5 points)

(b) What is the added value if the company finances this project with $682,044 worth of 16% debt which
requires an interest payment until maturity when the full principle is due? (4 points)

Corporate Finance (FINE 342) Page 2 of 10 Assignment 2

PROBLEM 1 CONTINUED
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(a) If the Albanic County Board of Commissioners approaches the MUS Company with an offer to raise the
needed $682,044 debt capital as 15% perpetual debt, should the company accept the offer? (6 points)

Corporate Finance (FINE 342) Page 3 of 10 Assignment 2

PROBLEM 2 (20 POINTS)

Suppose there are two firms ABC and XYZ. Suppose company ABC wants to take on a project that is unrelated
to its own business but reflects the business risks of company XYZ. The project promises to yield a perpetual
EBITDA of $200 that will grow at 2% each year. The project costs $1,000; and this $1,000 can be straight-line
depreciated for 10 years.
What is the value of the project under the different financing options listed below? Assume that the risk-free
rate is 8% and the market risk premium is 8.5%.

Company ABC Company XYZ

Debt-to-equity ratio = 1:3 Debt-to-equity ratio = 2:3

Cost of debt (pre-tax) = 10% Cost of debt (pre-tax) = 12%
TC = 40% Beta of equity = 1.5
TC= 40%

(a) Suppose the project was financed assuming that debt-to-equity would remain the same as the companys
given debt-to-equity for the life of the project. (10 POINTS)

Corporate Finance (FINE 342) Page 4 of 10 Assignment 2

PROBLEM 2 CONTINUED
Use this space to continue working on Problem 2

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PROBLEM 2 CONTINUED

(b) Suppose the project would be 100% equity financed. (5 POINTS)

(c) Suppose the project would be financed with $400 worth of perpetual debt. (5 POINTS)

Corporate Finance (FINE 342) Page 6 of 10 Assignment 2

PROBLEM 3 (10 POINTS)

Quipta is a semi-conductor manufacturing firm with three divisions. These are Tools (TL), which constitutes 40
percent of the assets of the firm, Digital Equipment (DE), which constitutes 25 percent of the assets and
Foundry Equipment (FD), which constitutes the remaining 35 percent of the assets. The unlevered betas of the
three divisions (defined as the beta of the division if it were independent and 100% equity financed) are UTL =
1.5, UDE =0.7 and UFD = 0.5. Quiptas debt-to-equity ratio is 3/7 and the corporate tax rate is 34%. The
expected return on the market portfolio is 13 %. Quipta can borrow at the risk free interest rate of 4%.
Calculate the expected return on the equity for Quipta.

Corporate Finance (FINE 342) Page 7 of 10 Assignment 2

PROBLEM 3 CONTINUED
Use this space to continue working on Problem 3

Corporate Finance (FINE 342) Page 8 of 10 Assignment 2

PROBLEM 4 (15 POINTS)

GrandPreex Inc. is an all-stock corporation that manufactures consumer goods. Sales are expected to be $500
million over the course of this year (realized at the end of this year), and are projected to grow at 10% annual
rate over the following two years. After that point, sales will stabilize. Management estimates that cash costs will
be 60% of revenue in each year. To achieve these sales projections, total investment in plant and equipment
will have to be $40 million this year (again, paid out at year end), $45 million next year, and will level off at $50
million thereafter. Depreciation charges are expected to match investment outlays in each of these years.
GrandPreex is in the 34% tax bracket. The required return on GrandPreexs assets is 16% [This is r0]. The firm
has 10 million shares outstanding, currently trading at $65 per share. There are no costs of financial distress.

Would you say that GrandPreexs shares are fairly priced?

Corporate Finance (FINE 342) Page 9 of 10 Assignment 2

PROBLEM 4 CONTINUED
Use this space to continue working on Problem 4

Corporate Finance (FINE 342) Page 10 of 10 Assignment 2