Answer To: Solve. show all work.
Akshay Kumar answered on Apr 29 2021
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FINANCIAL POLICY AND STRATEGY
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1
North Corp , which had a market value of equity of $2 billion and a beta of 1.50, announced that it was acquiring ABC, which had a market value of equity of $ 1 billion, and a beta of 1.30.
Neither firm had any debt in its financial structure at the time of the acquisition, and the corporate tax rate was 40%.
a. Estimate the beta for North Corp after the acquisition, assuming that the entire acquisition was financed with equity.
b. Assume that North Corp had to borrow the $ 1 billion to acquire ABC. Estimate the beta after the acquisition.
Answers
a
After the Acquisition, Beta of North Corp will be as follows
Particulars Market Value
(in Billions) Weights Beta Weighted
Average Beta
North Corp Market Value before acquisition 2 0.67 1.50 1.00
ABC Market Value 1 0.33 1.30 0.43
Total 3 1.00 1.43
Thus, After the Acquisition, Beta of North Corp will be 1.43
b
After borrowing the debt, beta would be :
If North Corp borrows $ 1 billion, then the beta would be the levered beta.
The unlevered beta is 1.43 (as calculated above) and levered beta will be :
BetaL BetaU * [1 + (1-tax rate) * D/E]
Now the Debt would be $1 billion and equity is $2 billion
BetaL 1.43 *( 1 + (1-0.4)*$1 billion/$2 billion
1.86
Thus, After the debt, Beta of North Corp will be 1.86
2
You are analyzing the beta for IBM and have broken down the company into four broad business groups, with market values and betas for each group.
Business Group Market Value of Equity Beta
Mainframes $ 2.0 billion 1.1
Personal Computers $ 2.0 billion 1.5
Software $ 1.0 billion 2
Printers $ 3.0 billion 1
a. Estimate the beta for IBM as a company. Is this beta going to be equal to the beta estimated by regressing past returns on IBM stock against a market index. Why or Why not?
b. If the treasury bond rate is 7.5%, estimate the cost of equity for IBM. Estimate the cost of equity for each division. Which cost of equity would you use to value the printer division?
c. Assume that IBM divests itself of the mainframe business and pays the cash out as a dividend. Estimate the beta for HP after the divestiture. (IBM had $ 1 billion in debt outstanding.)
Answers
a
Business Group Market Value of Equity Weights Beta Weighted
Average Beta
Mainframes 2 0.25 1.1 0.28
Personal Computers 2 0.25 1.5 0.38
Software 1 0.13 2 0.25
Printers 3 0.38 1 0.38
Total 8 1.00 1.28
Thus, Beta fir IBM company is 1.28
Beta calculated above will be not be equal to the beta estimated by regressing past returns on IBM stock against a market Index, due to any divisional structure and leverage changes from internal infrastructure within IBM which may have changed, the beta which was obtained by calculating the past returns against a market index will not be the same
b
Cost of Equity for IBM Risk Free Return + Market Risk Premium * Beta
7.5% + (1.28*5.2%)
6.5% + 6.656%
13.16%
Cost of Equity for IBM is 13.16%
Cost of Equity to be used to Value Printers Risk Free Return + Market Risk Premium * Beta
7.5% + (1*5.2%)
6.5% + 5.2%
11.70%
Cost of Equity to be used to Value Printers is 11.70%
c
IBM divests itself of the mainframe business, it will get 2 Billion in cash. As IBM has 1 Billion debt
Business Group Market Value of Equity Weights Beta Weighted
Average Un Levarged Beta
Personal Computers 2 0.25 1.5 0.38
Software 1 0.13 2 0.25
Printers 3 0.38 1 0.38
Total 6 0.75 1.00
Tax rate Assumed as 40%
BetaLeveraged
BetaL BetaU * [1 + (1-tax rate) * D/E]
1 *( 1 + (1-0.4)*$1 billion/$6 billion
1.10
Thus, leveraged Beta after diverment would be 1.10
3
The following table summarizes the percentage changes in operating income, percentage changes in revenue and betas for four pharmaceutical firms.
Firm % Change in Revenue % Change in Operating Income Beta
Firm A 27% 25% 1
Firm B 25% 32% 1.15
Firm C 23% 36% 1.3
Firm D 21% 40% 1.4
a. Calculate the degree of operating leverage for each of these firms.
b. Use the operating leverage to explain why these firms have different betas.
Answers
a - Degree of Operating Leverage % Change in Operating Income
% Change in Revenue
Firm % Change in Revenue % Change in
Operating Income DOL
Firm A 27% 25% 0.93
Firm B 25% 32% 1.28
Firm C 23% 36% 1.57
Firm D 21% 40% 1.90
b
Degree of operating Leverage Shows how much company's Operating Income or EBIT change with change in the Firm's Revenue. Higher the Degree of Operating Leverage, Higher the Risk for the firm If the Revenue of the Firm reduces, the income of the Firm 's whose DOL is higher would reduce more than then company whose DOL is less.
And with Higher risk, Higher Beta. That's why the Firm which has the Higher DOL, has the Higher Beta.
4
Given the following cash flow information about three projects, which one would you choose and why?
Year Project A Project B Project C
0 ($10,000) $5,000 ($15,000)
1 $8,000 $5,000 $10,000
2 $7,000 ($8,000) $10,000
The cost of capital is 12%.
a. Which project would you pick using the net present value rule?
b. Which project would you pick using the internal rate of return rule?
c. How would you explain the differences between the two rules? Which one would you rely on to make your choice?
Answers
a
Year Project A Project B Project C Discounting Factor
at 12% Discounted Cash Flows
Project A Discounted Cash Flows
Project B Discounted Cash Flows
Project C
0 ($10,000) $5,000 ($15,000) 1.00 (10,000.00) 5,000.00 (15,000.00)
1 $8,000 $5,000 $10,000 0.89 7,142.86 4,464.29 8,928.57
2 $7,000 ($8,000) $10,000 0.80 5,580.36 (6,377.55) 7,971.94
NPV 2,723.21 3,086.73 1,900.51
On the basis of NPV, Project B should be picked as it has highest NPV
b
Year Project A Project B Project C
0 ($10,000) $5,000 ($15,000)
1 $8,000 $5,000 $10,000
2 $7,000 ($8,000) $10,000
IRR 32.74% -13.99% 22%
On the basis of IRR, Project A should be picked as it has highest IRR
c
Under Net Present Value Method, those projects which generates positive NPV are viable projects for selection as only these projects will result into profit. The Project, which generates highest positive value is selected.
under Internal Rate of Return Rule, those projects whose IRR is higher or equals to the Cost of capital of the company are viable for selection. The Project, who has highest IRR is selected.
The IRR and NPV selects the projects differently because NPV assumes that project cash flows are reinvested at the discount rate while, IRR suffers from the limitation that it assumes that project cash flows are reinvested at the internal rate of return. Therefore, I would rely on net present value to make my choice.
5
You are graduating in soon and would like to start your own business. You collect the following information on the initial costs:
Cost of Plant and Equipment = $ 500000
Licensing and Legal Costs = $ 50000
You can claim an investment tax credit of 10% on plant and equipment. You also have been left a tidy inheritance that will cover the initial cost, and your estimated opportunity cost is 10%.
You estimate that you can sell 1 million bottles a year at $1 a bottle. You estimate your costs as follows:
Variable costs/bottle = 50 cents
Fixed Costs/ year = $ 200000
Adding up state, local, and federal taxes, you note that you will be in the 50% tax bracket.
To be conservative, you assume that you will terminate the business in 5 years and that you will get nothing from the plant and equipment as salvage (you also use straight line depreciation).
As a final consideration, you note that starting this business will mean that you will not be able to take the investment banking job you have been offered (which offered $ 75000 a year for the next 5 years). Should you take on the project?
Answers
Calculation of NPV for this Project
Incremental Future Cash Flows
Particulars Year 1 Year 2 Year 3 Year 4 Year...