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additional practice problem for the finance midterm
Typology: Cheat Sheet
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from the software business and 30% from its furniture business. The firm has equity with a market value
of $ 600 million and debt with a market value of $ 400 million. The firm has a levered beta of 1.30. The
firm is considering divesting its furniture business and repaying debt with the cash from the divestiture.
(The tax rate is 40%)
a. If the furniture business has an unlevered beta of 0.80, estimate the unlevered beta for Jewell Systems after the divestiture. b. Estimate the levered beta for Jewell after the divestiture and the repayment of the debt. c. How would your answer to (b) change if you were told that half the money would be used to buy back stock and the other half used to repay debt?
a. Current levered beta = 1. Unlevered beta for firm before divestiture = 1.3/(1+(1-.4)(400/600)) = 0. 0.9286 = Software beta (0.70) + 0.80 (0.30) Unlevered beta for software = (0.9286 - 0.24)/0.70 = 0.9837! This will be the unlevered beta after divestiture Debt after divestiture = 400 - 300 = 100 b. New levered beta = 0.9837 (1 + (1-.4) (100/600)) = 1. c. If half had been used to buy back stock, new Levered beta = 0.9837 (1 + (1-.4)(250/450)) = 1.
Interest Coverage Ratio Rating Default Spread
12.5 AAA 0.20%
9.50 - 12.50 AA 0.50%
7.50 – 9.50 A+ 0.80%
6.00 – 7.50 A 1.00%
4.50 – 6.00 A- 1.25%
a. Interest coverage ratio =2000/400 5. Rating based on ratio = A- Pre-tax cost of debt = 7.25%
b. Market value of debt = $5,
=400*(1-1.0725^- 8)/0.0725+6000/1.0725^ c. Levered beta for LT&T = 0.70 (1+(1-.4)(5793/10000)) = 0. Cost of equity for LT&t = 6% + 0.94(5.5%) = 11.19% d. Cost of capital = 11.19% (10000/15793) + 7.25% (1-.4) (5793/15793) = 8.68%
Value of Debt Probability of Default $2,500,000 0% 5,000,000 8% 7,500,000 20.5% 8,000,000 30% 9,000,000 45% 10,000,000 52.5% 12,500,000 70%
a. What is the op�mal capital structure when bankruptcy costs are considered? b. What will the value of the firm be at this op�mal capital structure?
See excel file.