PROBLEM 4-1

Given Solutio
As a summer intern you are asked to prepare a spreadsheet
calculating the project free cash flow associated with a project
your employer is considering. Initially your boss assumes that
no debt would be used to fund the project. During your
presentation to the committee that evaluates projects, you
learn that, in fact, the project will be financed with 25% debt.
Are the following statements are either true or false (explain
your answer):

Answer:

a. You need to go back to your office and adjust the project's free cash flows to include the interest on the debt.
 
 
b. You need to go back to your office and adjust the project cash flows to update the taxes paid due to the tax shield
provided by taking on debt.
 
 
c. Your cash flow model does not need to be updated because the financing of the project does not affect the free
cash flow calculation.
 
 
d. The WACC should be lowered to reflect the cheaper cost of the debt financing.
 
 Solution Legend
= Value given in problem
= Formula/Calculation/Analysis required
= Qualitative analysis or Short answer required
= Goal Seek or Solver cell
= Crystal Ball Input
= Crystal Ball Output

No because project FCF includes interests since it represents the CF to both project's inv
nterest on the
no debt.
bec

aid due to the tax shield

The tax shield would be reflected in the calculation of WACC => double calculation
oes not affect the free

Yes

Depends
ts the CF to both project's investors and creditors

C => double calculation

 PROBLEM 4-4

Given Solution Legend

Face value $ 1,000.00 = Value given in problem
Current price $ 1,081.26 = Formula/Calculation/Analysis required
Maturity 8 years = Qualitative analysis or Short answer required
Terms semi-annual interest only = Goal Seek or Solver cell
Coupon rate 7.25% = Crystal Ball Input
= Crystal Ball Output
Solution
Semi-annual YTM 2.98% Note: To convert the semi-annual YTM to it's annual YTM equivalent we
Annual YTM 6.05% perform the following computation: = (1 + .0298)^2 - 1.
 Solution Legend
= Value given in problem
= Formula/Calculation/Analysis required
= Qualitative analysis or Short answer required
= Goal Seek or Solver cell
= Crystal Ball Input
= Crystal Ball Output

convert the semi-annual YTM to it's annual YTM equivalent we

e following computation: = (1 + .0298)^2 - 1.
 PROBLEM 4-7

Given
Analysis of unlevered equity beta with risky debt beta = .30 Tax Rate

Levered Debt/Equity Assumed

Company Name Equity Betas Capitalization Debt Betas
Eastman Chemical Co. (EMN)
Celanese Corp. (CE)
Dow Chemical Company (DOW)

Average

b. Solution
Analysis of Sterling
Analysis based on simple average of unlevered equity betas
beta unlevered D/E beta debt D/E
a. Solution: Solution Legend

Unlevered
Equity Betas

beta levered
 Solution Legend
= Value given in problem
= Formula/Calculation/Analysis required
= Qualitative analysis or Short answer required
= Goal Seek or Solver cell
= Crystal Ball Input
= Crystal Ball Output
 PROBLEM 4-8

Given
December 31, 2014
Liabilities and Owner's Capital Balance Sheet Invested Capital
(Book Values) (Market Values)
Current liabilities
Accounts payable $ 8,250,000
Notes payable - -
Other current liabilities` 7,266,000
Total current liabilities $ 15,516,000 $ -

Long-term debt (8.5% interest paid $ 420,000,000 $ 434,091,171

semi-annually, due in 2015)
Total liabilities $ 435,516,000 $ 434,091,171

Owners' capital
Common stock ($1 par value per share) $ 40,000,000

Paid-in-capital 100,025,000
Accumulated earnings 255,000,000
Total owners' capital $ 395,025,000 $ 900,000,000
Total liabilities and owners' capital $ 830,541,000 $ 1,334,091,171

Capital Market Data

Treasury Bond Yield 5.42%
Market Risk Premium 5.00%
Unlevered equity beta (SIC 4924) 0.90
Stock price $ 22.50
Market capitalization $ 900,000,000
Yield on debt 8.00%
Bond beta 0.30
Short-term interest bearing debt
New long-term debt total $ -
Tax Rate 40.00%

Solution
Step 1: Evaluate the capital structure weights
Enterprise Value = Market $ 1,334,091,171
Capitalization + Debt
Debt / Enterprise Value 32.54%
Equity / Enterprise Value 67.46%

Step 2: Estimate the costs of Financing

Debt (after taxes) 4.80%
Debt/Equity Ratio 48.23%
 Equity 11%
Levered equity beta 1.19

Step 3: Calculate the WACC

WACC 9.23%

Capital Structure Weight

Source of Capital (Proportion) After-Tax Cost
Debt 32.54% 4.80%
Equity 67.46% 11.37%
WACC
 Solution Legend
= Value given in problem
= Formula/Calculation/Analysis required
= Qualitative analysis or Short answer required
= Goal Seek or Solver cell
= Crystal Ball Input

= Crystal Ball Output

Weighted After-Tax Cost
0.01562
0.07668
9%
 PROBLEM 4-9

Given
Maturity 5 years
Terms
Face value $ 1,000
Coupon rate 12.00%
Offering price $ 800

Solution
a.
Promised YTM = 18.46% strong assumption: bond will never go o

b. (Note: the discussion of this analysis is found in the Appendix to the chapter)
Bond Rating Caa/CCC
10 Year Treasury Yield = 5.02%
Coupon 12.00%
Principal $ 1,000.00
Price $ 800.00
Maturity 5 years
Recovery Rate 50.00%
Default Probability 5.00%

Default Cash Flows

Year 1 2 3
0 $ (800) $ (800) $ (800)
1 560 120 120
2 560 120
3 560
4
5

Expected yield to maturity if default occurs in this year -30.00% -8.50% 0.00%
Probability of default in each year 5.00% 5.00% 5.00%
Weighted YTM = E(YTM) x Pb of default -1.500% -0.425% 0.000%
Average YTM based on Expected Cash Flows 12.51%

YTM Spread 13.44%

Cost of Debt Spread 7.49%
 Solution Legend
= Value given in problem
sumption: bond will never go on default = Formula/Calculation/Analysis requ
= Qualitative analysis or Short answ
= Goal Seek or Solver cell
= Crystal Ball Input
= Crystal Ball Output

Cash Flows
Promised
4 5 Cash Flow
$ (800) $ (800) $ (800)
120 120 120
120 120 120
120 120 120
560 120 120
560 1,120
18.46% Promised YTM

4.48% 7.21% 18.46%

5.00% 5.00% 75.00%
0.224% 0.360% 13.847%
Expected YTM =
Cost of debt
 Solution Legend
= Value given in problem
= Formula/Calculation/Analysis required
= Qualitative analysis or Short answer required
= Goal Seek or Solver cell
= Crystal Ball Input
= Crystal Ball Output
 PROBLEM 4-12

Given
December 31, 2014

Balance Sheet Invested Capital

Liabilities and Owners' Capital (Book Values) (Market Values)
Current Liabilities
Accounts payable $ 17,550,000
Notes payable 20,000,000 20,000,000
Other current liabilities` 22,266,000
Total current liabilities $ 59,816,000 $ 20,000,000
Long-term debt (7.5% interest paid semianually, due
in 2020) $ 650,000,000 $ 624,385,826
Total liabilities $ 709,816,000 $ 644,385,826
Owners' Capital
Common stock ($1 par value per share) $ 20,000,000
Paid-in-capital 200,025,000
Accumulated earnings 255,000,000
Total owners' capital $ 475,025,000 $ 1,560,000,000
Total liabilities and owners' capital $ 1,184,841,000 $ 2,204,385,826

US Treasury Bond Yield 5.42%

Estimated Market or Equity Risk Premium 5.00%
Current Share Price $ 78.00
Market value of owners' equity 1,560,000,000
Current yield on the firm's long-term debt 8.50%
Current yield on the firm's short-term notes 9.00%
Dollar value of short term notes outstanding $ 20,000,000
Corporate tax rate 35%

Solution

a. What are Harriston's capital structure weights?

Enterprise value = Market capitalization + Debt $ 2,204,385,826
Notes payable / Enterprise Value 0.91%
Long-Term Debt / Enterprise Value 28.32%
Equity / Enterprise Value 70.77%

b. What is Harriston's cost of equity capital using the CAPM?

After-Tax Cost of Sources of Capital
Notes Payable (after-taxes) 5.85000%
Long-term Debt (after-taxes) 5.53%
Levered equity beta 1.20
Equity (using the CAPM) 11.42%
c. What is Harriston's WACC?
Capital Structure Weight
Source of Capital (Proportion) After-Tax Cost
Notes Payable 0.91% 5.85%
Long-term Debt 28.32% 5.53%
Equity 71% 11.42%
100.00% WACC
 Solution Legend
$624,385,826.49
= Value given in problem
= Formula/Calculation/Analysis required
= Qualitative analysis or Short answer required
= Goal Seek or Solver cell
= Crystal Ball Input
= Crystal Ball Output
Weighted After-
Tax Cost
0.05%
1.56%
8.08%
9.6997%
 PROBLEM 4-13

a. Analysis of airline carrier's unlevered beta

Levered Equity Debt/Equity Assumed Debt

Company Name Betas Capitalization Betas
American Airlines (AMR) 1.01 25.61% 0.30
Delta Airlines (DALR.PK) 0.96 21.77% 0.40
Jet Blue (JBLU) 0.73 58.26% 0.30
Southwest Airlines (LUV) (Note 1) 0.97 -6.16% 0.20
Average
Unlevered
Equity Beta =
(Levered Beta +
D/E * Debt
Beta)/(1 + D/E)
DE-LEVERING PROCESS
b. Analysis of Southwest Airlines Levered Beta

Analysis based on simple average of unlevered equity betas

Unlevered Equity Beta (Asset Beta) D/E Debt beta beta levered
0.8293 -6.16% 0.20 0.79

c. Special concerns regarding estimation of cost of equity

 Unlevered
Equity Betas
0.87 Solution Legend
0.86 = Value given in problem
0.57 = Formula/Calculation/Analysis required
1.02 = Qualitative analysis or Short answer required
0.8293 = Goal Seek or Solver cell

= Crystal Ball Input

= Crystal Ball Output
 PROBLEM 4-14

a. MRP
Fama French (FF) Coefficients

FF Cost
Company Name b s h of Equity CAPM Beta
SBC Communications (AT&T) 1.0603 -1.4998 1.0776 8.00% 0.62
Verizon Communications 1.1113 -0.9541 0.639 8.16% 0.79

SBC Communications (AT&T)

Coefficient Risk
Coefficients Estimates Premia Product
Fama French
b 1.0603 5.00% 5.30% estimate of the
s (1.4998) 3.36% -5.04% cost of equity
h 1.0776 4.40% 4.74%
Risk premium = 5.00%
+ Risk free rate = 3.00%
= Cost of equity 8.00%

Verizon Communications
Coefficient Risk
Coefficients Estimates Premia Product Coefficient
b 1.1113 5.00% 5.56% positive
s -0.9541 3.36% -3.21% negative
h 0.639 4.40% 2.81% positive
Risk premium = 5.16%
+ Risk free rate = 3.00%
= Cost of equity 8.16%

b.
 5%

CAPM
minus FF
CAPM Cost Cost of
of Equity Equity
6.100% -1.90%
6.950% -1.21%

a French CAPM estimate of

mate of the the cost of equity Solution Legend
of equity = Value given in problem
= Formula/Calculation/Analysis required
= Qualitative analysis or Short answer required
= Goal Seek or Solver cell
= Crystal Ball Input
= Crystal Ball Output

Explanation
the risk from market is greater than risk from market to book ratio
if u run the portfolio and include Verizon using FF three-factor, then risk/exposure for ur portfolio will be lowered
it indicates the level of risk/exposure company facing for that factor
folio will be lowered
 PROBLEM 4-17

a. Estimated Firm or Asset Beta

Levered Debt/Equity
Company Name Equity Betas Capitalization
Comp #1 1.50 15.00%
Comp #2 2.10 30.00%
Estimated Asset Beta =

b. Estimation of the cost of equity

Analysis based on simple average of unlevered equity betas
beta unlevered D/E beta debt
1.4960 20.00% 0.20

Risk free rate 3.00%

Market risk premium 5.00%
Equity beta (levered) 1.7552
Estimated cost of equity 11.78%

c. Estimate of the WACC

Before tax cost of debt 4.00%
Tax rate 35.00%
After-tax
Proportions Cost
Debt 20.00% 0.026
Equity 80.00% 0.118
WACC
OBLEM 4-17

Unlevered
Assumed Equity
Debt Betas Betas
0.20 1.3304 Solution Legend
0.20 1.6615 = Value given in problem
Estimated Asset Beta = 1.4960 = Formula/Calculation/Analysis required
= Qualitative analysis or Short answer required
= Goal Seek or Solver cell
= Crystal Ball Input
beta levered = Crystal Ball Output
1.7552

Product
0.0052
0.0942
0.0994