Boston Turkey has 10 million shares outstanding and no debt. Earnings before interest and tax (EBIT) are projected for three scenarios: $20 million under a recession, $40 million for normal conditions, $60 million for an economic expansion.? The probability for the normal scenario is 40% and the probability is 30% each for the other scenarios
4463 Financial Management
Assignment 2-Winter 2016 ? Professor Christine Panasian
Due: In class March 22nd, 2016.
Note: If you handwrite your assignment, please use only pen to write your answers (no pencil will be
Problem 1 (18 points)
Boston Turkey has 10 million shares outstanding and no debt. Earnings before interest and tax (EBIT) are
projected for three scenarios: $20 million under a recession, $40 million for normal conditions, $60
million for an economic expansion. The probability for the normal scenario is 40% and the probability is
30% each for the other scenarios.
Boston Turkey is considering a recapitalization plan. Debt would be issued for $210 million with an 8.75%
interest rate. The proceeds would be used to buy back 3 million shares at their book value of $70 a
share. The corporate tax rate is 38%.
Write a brief report to discuss Boston Turkey?s recapitalization plan. In particular, for each of the three
scenarios, calculate Boston Turkey?s EPS and return on investment in two situations:
first before any new debt is issued and then
after the recapitalization.
Calculate the leverage-indifference EBIT level and discuss the risk associated with recapitalization. Briefly
explain why you would or would not recommend Boston Turkey to proceed with the recapitalization
Calculate and include in your answer the expected EPS and standard deviation of EPS in each of the two
Problem 2 (20 points)
Harris Corp has 4 million outstanding common shares, and paid $2.15 per share in dividends last year.
The current share price is $28. For the past 6 years the company has maintained a policy of paying out
65% of earnings as cash dividends. Exhibit below contains the projected balance sheet for Harris Corp
for the upcoming year end, assuming no dividends. Earnings after tax are projected at $14,153,846.15.
a). If Harris Corp maintains its steady 65% cash dividend payout policy, what will be the total cash
dividend payout and the total debt-to-equity ratio following the payout. What dividend payment will a
holder of 300 common shares receive? Show your calculations.
b). Suppose that Harris Corp retains all its cash in order to finance the purchase of a large piece of land
that will be used for future development of a new production centre. Instead of a cash dividend, a 30%
stock dividend will be paid. Assess the impact of a stock dividend as follows:
i). What will the holder of 300 common shares receive?
ii). How will the balance sheet change, given the stock dividend, and what will the total debt-to-equity
ratio be if earnings are projected to be unchanged after the land purchase?
iii). What can this same shareholder expect to receive in cash dividends next year if Harris returns to its
steady 65% cash dividend payout policy?
c). Suppose that Harris has no investment plans and would like to payout 65% of its earnings to
shareholders in the form of a share repurchase this year, and then will return to its policy of paying cash
dividends in its future years. Earnings are projected to be unchanged. Assess the impact of a share
repurchase as follows:
i). Calculate the number of shares Harris can repurchase if the share price remains at $28.
ii). Calculate the number of shares that will remain outstanding.
iii). In the next year, when the cash dividends are resumed, Calculate the per-share dividend and amount
of dividends to be received by the former owner of 300 shares.
d). Referring to your analysis in part a) to c) briefly explain which of the three policies would be most
attractive to shareholders.
Projected Balance Sheet Harris Corp.
Liabilities and Shareholders? Equity
Long Term Debt
Problem 3 (6 points)
An investor has both shares and bonds in his investment portfolio. The bond holdings include two issues,
each with a $1,000 face value. Issue A is for a natural gas pipeline firm with very stable earnings. The
bonds pay an interest rate of 3% each half-year, and the bonds have 2 years until they mature. The
current market yield on comparable bonds if newly issued would be 2% each half-year. The investor
owns 200 of these bonds. The investor also owns 150 Issue B bonds, issued by a high-tech robotics firm.
These bonds pay an interest rate of 8% per annum and mature in 4 years. The current market yield on
comparable bonds if newly issued would be 10% per annum.
a) Calculate the value of each bond issue holding and of the bond portfolio as a whole.
b) Explain which of the bond holdings, Issue A or Issue B, is riskier. Consider both Business risk and
interest-rate risk in your explanation.
Problem 4 (18points)
You are the CFO of a major corporation and are making a decision on how much you can afford to
borrow. Currently the firm has 15 million shares outstanding, and the market price per share is $40. The
firm had also $180 million market value of debt outstanding. The company is rated BB right now, stock
has a beta of 1.4 and the T-bill rate is 6% (market risk premium is 5%) Marginal tax rate of the firm is
40%. Your finance division estimated that the rating would change to a B if you borrow an additional
$100million. The rate for BB ratings is now 10% and for B ratings is 11.5%.
1. Given the marginal benefits and costs of debt financing do you recommend to go ahead with
2. What is your calculation of the WACC with and without the $100 million new borrowing?
3. If you decide to borrow $100 million what will be the new price per share of the company?
4. Consider that you have a project that requires investment of $100 million and has expected
before-tax revenues of $50 million and costs of $30 million per year forever. Is this a good
project to undertake? Why or why not?
5. If you are told that the cash flows from the above project in part 4. are certain, does that make a
difference in your decision?
Problem 5 (20 points)
A small private firm has hired you as a consultant for a decision they need to make on their capital
structure. The firm has EBIT per year of $500,000. Its book value of equity is $1.5 million but its
estimated market value is $6 million. Firm also has $1 million in debt outstanding and paid interest
expense of $80,000 last year. You estimate that the firm has a A rating based on its interest coverage
ratio of comparable firms and would be able to borrow at 8.25%. A good estimation for the beta of the
firm based on comparable publicly traded firms is 1.05 and these firms have an average debt to equity
ratio of 25%. Tax rate is 40%.
1. Estimate the cost of capital for the firm
2. If the firm doubles its debt from $1 million to $2 million and the average rate at which they can
borrow will be 9%, calculate the new cost of capital and the new estimated firm value.
3. You also have run a multiple regression of debt ratios of other firms against firm characteristics
and obtained the following regression estimate:
Debt Ratio = 0.15 + 1.05 (EBIT/Value of Firm) ? 0.10 (beta).
What is the debt ratio of your private firm based on the above result?
4. What are your concerns in applying the above results derived from using large, public firms to
estimate optimum leverage for the small, private firm?
Problem 6 (18points)
IHOP is a family restaurant chain and it is re-examining its policy of paying minimal dividends to its
shareholders. In 2005 they reported a net income of $66 million and capital expenditures of $150
million. Depreciation was $50 million and working capital was $43 million while sales amounted to $783
million. They project the following over the next 5 years:
Capital expenditures will grow at 10% per year and depreciation will grow at 15 percent per year.
Working capital as a percentage of revenues will stay at the same levels as in 2005 and revenues
are growing at 10 percent a year.
The company has no debt and does not plan to use any debt over the next 5 years.
a) Estimate how much cash IHOP has over the next five years to pay out to its shareholders over
the next 5 years.
b) What happens if the firm plans to change its capital structure by borrowing 25% of its net capital
expenditures and working capital needs?
c) Assuming you are the CEO and decide to continue not to pay dividends. A group of dissident
shareholders are asking why you are not paying out your free cash-flow to equity to the
shareholders. How would your defend your decision? How receptive would the shareholders be
to your explanation? Does it make a difference if IHOP has earned a ROE of 25% over the last 5
years and its beta is 1.2?
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