Corporation Finance Homework Assignment #4

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Corporation Finance

Homework Assignment #4:

1.  You operate a firm which will last one year.  At the end of the year, the firm will generate its single cash flow.  It will either be 140 or 40 – each equally likely.  (Assume all cash flows are in $million.)  You also have debt outstanding with face value of 100.  You are the sole equity holder.  A new project is now available to you but it requires an investment of 30, of which you have none.  If you can obtain financing for the project and undertake it, the project will generate 50 next year (period).  Say that the existing debt prevents you from issuing any new debt so that you must issue shares of equity.  Assume the following: a discount rate of zero; and you currently have 2 million shares outstanding.

a) Would you issue new equity and undertake the new project?

b) Now assume that the bank offers to forgive a little over 20 so that your new debt face value is just under 80.  Now, would you undertake the project?

c) Would it surprise you that the bank may have unilaterally offered to forgive debt?  Explain.

2. You are the CEO of Underlevered, Inc. and are planning to increase your firm's leverage in a recapitalization by issuing $100 million of debt to be entirely used to buy some of the 100 million outstanding shares of equity. Once executed, this will put your new total amount of debt at $300 million.  You have been informed that your firm is so underlevered that the AAA credit rating of your firm's current debt will remain intact with the additional debt issue, and the firm’s stock price will likely increase from its current level of $10 per share. You will make the surprise announcement of the recapitalization May 3^rd and will definitely execute the transaction in a month on June 3^rd.   Also, note that your equity returns are similar to the typical firm: half dividends and half capital gains.

The following describes the existing tax code as of May 3^rd:

• Capital Gains Tax is 20%

• top Personal Income Tax is 40%

• Corporate Tax Rate is 34%

• Your investors typically postpone their capital gains by not selling their shares for years.  Assume the implication of this is that the effective capital gains tax rate is cut in half.

Nothing else changes for the rest of the month of May.  However, the government makes a surprise announcement on June 1^st instituting a new tax code with the rates described as follows:

• Capital Gains Tax is 15%

• top Personal Income Tax is 35%

• Corporate Tax Rate is 40%

• The government has enacted a law whereby investors must mark-to-market their investment portfolios every year for tax purposes. That is, capital gains taxes can no longer be postponed.

Fill in the table below with your estimates of each value at the time noted based on the tax implications of the scheduled recapitalization. Incorporate only the tax effects -- ie, ignore agency problems, information asymmetries, and any other possible issues.  Also, assume that the new tax code would have no effect on the firm’s current stock price were you to not alter the capital structure.  As a consequence, when the tax code changes the value of the firm will change in exact accordance to how the Relative Tax Advantage of debt changes.