Docsity
Docsity

Prepare for your exams
Prepare for your exams

Study with the several resources on Docsity


Earn points to download
Earn points to download

Earn points by helping other students or get them with a premium plan


Guidelines and tips
Guidelines and tips

midterm extra questions, Cheat Sheet of Finance

additional practice problem for the finance midterm

Typology: Cheat Sheet

2023/2024

Uploaded on 10/15/2023

alexander-panas
alexander-panas 🇺🇸

1 document

1 / 4

Toggle sidebar

This page cannot be seen from the preview

Don't miss anything!

bg1
Additional practice problems for Midterm
1. Jewell Systems is a firm that manufactures computer furniture and software. It derives 70% of its value
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 =
1.30
Unlevered beta for firm before divestiture = 1.3/(1+(1-.4)(400/600)) =
0.9286
0.9286 = Software beta (0.70) + 0.80 (0.30)
0.9837
! This will be the unlevered beta after divestiture
Debt after divestiture = 400 - 300 =
100
1.0821
c. If half had been used to buy back stock,
1.3116
2. LT&T, a telecommunica�ons firm, reported earnings before interest and taxes of $ 2 billion and
interest expenses of $ 400 million. The book value of debt at the end of the year was $ 6 billion, and the
average maturity of the debt is 8 years. The firm has 250 million shares outstanding, trading at $ 40 a
share. The table below summarizes the rela�onship between interest coverage ra�os and ra�ngs for
large U.S. firms.
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%
pf3
pf4

Partial preview of the text

Download midterm extra questions and more Cheat Sheet Finance in PDF only on Docsity!

Additional practice problems for Midterm

1. Jewell Systems is a firm that manufactures computer furniture and software. It derives 70% of its value

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.

  1. LT&T, a telecommunica�ons firm, reported earnings before interest and taxes of $ 2 billion and interest expenses of $ 400 million. The book value of debt at the end of the year was $ 6 billion, and the average maturity of the debt is 8 years. The firm has 250 million shares outstanding, trading at $ 40 a share. The table below summarizes the rela�onship between interest coverage ra�os and ra�ngs for large U.S. firms.

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%

3.50 – 4.50 BBB 1.50%

3.00 – 3.50 BB 2.50%

2.50 – 3.00 B+ 3.00%

2.00 - 2.50 B 3.75%

1.50 – 2.00 B- 4.75%

1.25 – 1.50 CCC 6.00%

0.80 – 1.25 CC 7.50%

0.50 – 0.80 C 9.00%

< 0.65 D 11.00%

a. Estimate a synthetic rating for LT&T, based upon the interest coverage ratio.

b. Estimate the market value of LT&T debt.

c. If the unlevered beta for telecommunications firms is 0.70, estimate the cost of equity for LT&T.

The firm faces a tax rate of 40%. (The riskfree rate is 6% and the market risk premium is 5.5%)

d. Estimate the cost of capital for LT&T.

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%

  1. Ndir, Inc., an unlevered firm, has an expected EBIT of $2mil per year. Nadir’s tax rate is 40%, and the market value is V=E=$12 mil. Management is considering the use of debt; debt would be issued and used to buy back stock, and the size of the firm would remain constant. The default-free interest rate on debt is 12%. Since interest expense is tax deduc�ble, the value of the firm will tend to increase as debt is added to the capital structure but there will be an offset in the form of the rising cost of bankruptcy. The firm/s analysts have es�mated that the present value of any bankruptcy cost is approximately $8mil and the probability of bankruptcy will increase with leverage according to the following schedule:

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.