PROBLEM SET - CAPITAL STRUCTURE AND DCF VALUATION EXERCISES

Q1. Determining target leverage. You judge that a firm has an operating profit margin of 6% in a realistic- worst-case scenario, and it is considered quite a vulnerable business, so that it would be prudent to target an interest coverage ratio of 3× in that situation.  You have the following information from its most recent accounts:

Assume that current bond market interest rate conditions are described by:

a. Determine a target level of debt for the firm, both in $ and as a market value ratio to net capital. [Hint: work out three different scenarios, one for each of the three interest rates given in the table, and then pick the answer that is internally consistent.]

b. Using numbers, explain what the firm's CFO must do (Issue debt or equity? Retire debt? Buy back equity and/or pay a dividend? How much?) In order to reach the target capital structure that you propose.

Q2. A wealthy donor endows a chaired professorship at SIPA. If the interest rate is 5% how much must she set aside today to provide the following end-of-year salary payment alternatives?

a. $150,000 per year for 15 years

b. $150,000 per year in perpetuity

c. a perpetuity that pays $150,000 the first year and grows at 1% annually thereafter.

Q3. You wish to borrow $175,000 from a bank and to repay it in ten equal end-of-year payments, including interest. If the bank wants to earn a 6% rate of return on the loan, what should the payments be? How does your answer change if you postpone the start date (but not the end date) of the repayments until the end of the fourth year after taking on the loan? Ignore taxes and default risk. What is an example of this type of loan?

Q4. You pay $950 to buy a bond with 8 years left to maturity, a $1,000 face value, and a 6% coupon (paid semi-annually).

a. What is your yield to maturity?

b. If the yield to maturity on this bond two years later is 5%, what is its price?

Q5. Your company is not in good shape. You raised $200m in an IPO last year, but now you anticipate after- tax cash flows of minus $18m a year for the next five years. However, if you invest in a one-time promotional campaign costing $70m this year, then over the next five years your annual after-tax cash flows will be a positive but meager $4m per year. Assume that you plan to stay in business and that the discount rate is 12%.

a. What is the NPV of the promotional campaign?

b. What is its IRR?

c. Is it worth investing in the promotional campaign? Why or why not?

Q6. Consider the following deals and the associated cash flows:

a. Find the NPV of each project at a 10% required rate of return. Based on your analysis, which project should be taken?

b. Find the IRR of each project. Based on this analysis, which project should be taken?

c. What is the payback period of each project, rounded to the nearest month?

d. If you can only choose one, which project would you recommend to a client? Why?

e. Now assume that your required rate of return is 16%. How does this alter your analysis and why?

Q7. You own a railway line that requires no maintenance, will produce a net cash flow of $150 million next year, and will last forever. Unfortunately, the volume of freight is expected to decline by 5% per year.

[Hint: a negative growth rate does not invalidate the approach you would use for a growing company]

a. If the discount rate is 13% and the railroad lasts forever, what is it worth today?

b. If the railway line is abandoned at the end of 15 years (and the real estate, scrap metal, etc. is liquidated for $200 million after tax), what is it worth today?

Q8. Earnings per share will be $10.50 next year for the Premium Corporation. Premium does business in a highly competitive industry where the realized return on equity (RIR) for most companies is very close to the 12% required return on equity. Citing little change in Premium's stock price over the last five years, management is contemplating a change in strategy. Rather than continue its current 40% dividend payout, the company is considering reducing its payout to 20% and using the additional funds to fuel growth.  Added growth, they believe, will benefit shareholders and lead to a rise in Premium's stock price.

a. Find the growth rates implied by Premium's old and new payout policies. Using these growth rate and the constant growth model as a basis for valuing Premium stock, find the price today of Premium stock under these two policies.

b. Using the same assumptions as above, find the stock price for Premium one year from now under each of the two dividend policies.

c. Using the conclusions you drew in a. and b. above, explain whether the new payout policy creates value. If your conclusions to a. and b. seem contradictory in the context of whether growth generates value, how do you reconcile them?

d. Suppose that Premium keeps its 40% payout policy but discovers a new business opportunity that enables it to earn an enhanced RIR of 14% on its reinvested earnings. How fast will Premium's earnings and dividends grow? What is the value of Premium's stock today under these assumptions?

e. Premium finds that, unfortunately, the enhanced opportunity is only temporary. The enhanced RIR of 14% will only be available for the earnings reinvested in the next three years; after that, the reinvestment return falls back to its earlier value. Value Premium's stock under these circumstances.