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Answer the following problems clearly, completely, yet concisely.

1. Lockheed Martin’s management desires to find out whether they have excess debt capacity. Its present market value of equity is $40 b and its book value of debt is $ 4b. The company’s EBIT last year was about $4b. The present beta of the company’s stock is 0.5, marginal tax rate is 30%. Suppose that prtesent five-year Treasuries yield 2.0% and ten-year Treasuries yields 3.0%. For cost of equity calculation, suppose that risk-free rate is 3% and market risk-premium is 4%. Using the table below as broad guidelines, will the firm minimize WACC at no debt, present level of debt, 25% debt, or 50% debt? Describe all your steps in the calculation. Suppose that the firm size will remain the same under all scenarios (Debt issued will be used to repurchase shares).

                                         AAA       AA      A      BBB     BB     B         CCC
EBIT interest coverage (x)  23.8        19.5   8.0     4.7     2.5    1.2       0.4
Five year yield spreads       50            57     60      120    280    525      900
Ten year yield spreads       64            72      87     160     350   600      1320

2. a. You are engineering a Leveraged-Buy-Out (LBO) of ACME Industries, an industrial bottle maker. After the LBO, the firm would be financed with 90% debt and 10% equity. Fred Farber, the CEO, will own 30% of the shares. Fred thinks that the proposed capital structure is too highly levered and points out that, in the first few years, the firm will not be able to use all its debt tax shields. Initially, the interest payments are $400m per year and EBIT is only $300m per year. However, EBIT is projected to increase 20% per year for the next five years. Provide Fred a true tax argument that supports the high level of debt. Take into account his personal taxes as well as corporate taxes. Does your tax argument depend on whether Fred wants to dilute his ownership of the company in the future?

b. Debt is always cheaper than equity. How will you respond to this comment?

3. a. Provide at least 4 reasons why the firm might prefer to repurchase stock than to pay out dividends. What factors have influenced the strong growth in repurchase over last two decades?

b. Dividends are tangible. Unrecognized capital gain is paper money. Therefore Dividends are always preferable to no payouts by the firm. Discuss.

4. a. What are short-term and long-term market reactions after an IPO? What are the potential reasons for these returns?

b. How do you describe the lack of IPO activity in the United States in recent years?

5. Consider a recent merger between two major corporations. describe the terms of the merger (cash or stock, premium, changes in management / directors, etc.). describe the motivations behind these terms and whether you feel that these are appropriate.

6. Using exs from news reports within the last one year about public companies, describe how the concepts of adverse selection and moral hazard. describe the problems created in these situations and the extent of the problems that this has created for the firms. How have these firms attempted to reduce these problems?

7. Consider an intermediary (preferably the firm you work for). describe how your firm creates value for its clients based on taxes, transactions costs, information asymmetry, regulations, and efficient markets.

8. In May 2003, Gencorp acquired Sequa Corp.’s propulsion subsidiary ARC for $133million in cash and $11 million in transactions costs. Table below lists selected information about ARC at the time of acquisition (‘000s):
Sales $ 300,000
Operating income (loss) $ 8,000
Total assets $ 250,000
Capital expenditures $ 20,000
Depreciation and amortization $ 25,000
Intangible Assets (process technology) $ 20,000
Over the next three years,

a. ARC sales will increase by 5% each year (with or without the merger). Part of the reason for the merger is Gencorp’s expectation that ARC would achieve this growth at the expense of Gencorp’s propulsion division (with or without the merger).

b. Operating income will remain as the same fraction of sales.

c. Capital spending needs to be maintained at current levels and depreciation will remain constant. But, the acquisition lowers Gencorp’s capital spending, without any further loss in sales, by $5,000 a year, for the next three years. Assume that the lowered capital expenditures will have no impact on depreciation. After three years,

d. free cash flows to the firm (ARC) are expected to grow at a constant rate of 3% forever, with or without the merger. No impact on Gencorp after year 3.
The average beta for the industry is 1.5, with a market value based debt ratio of 50%. As part of the combined firm the debt ratio can be increased to 60% without any change in the pre-tax cost of debt of 7.5%. Market risk premium is 4% and risk- free rate is 5%. Marginal tax rate is 30%. Is the acquisition beneficial for Gencorp’s shareholders?

Financial Management, Finance

  • Category:- Financial Management
  • Reference No.:- M91297

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