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FIN303 Financial Management

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Question:

Question 1

You are considering taking out an $800,000 30-year loan with equal monthly payments with a bank, which quotes annual rates on its deposits and loans of 1.2% and 3.6%, respectively.

(a) Without constructing a loan amortization schedule,

(i) calculate the amount of interest that will be paid in the first month of the 25th year into the loan.

(ii) calculate the total amount of interest that will be paid over the life of the loan.

(b) Interpret your answer for (a)(ii) and discuss the limitation(s), if any, of such an interpretation.

(c) Calculate the present value of the loan payments using a discount rate of 1.2%.

(d) Interpret your answer for (c) as well as the difference between that answer and the actual loan principal. What can explain this difference?

The prevailing corporate marginal tax rate is 20%, the expected return on the market portfolio is 15%, and the risk-free rate is 5%. Assume the firm’s cost of debt does not vary with capital structure and financial distress is costless.

(a) (i) Calculate and justify a suitable weighted average cost of capital based on T. Holdings’ existing capital structure.

(ii) Justify and calculate a suitable discount rate for the telecommunications project.

(b) (i) Compute operating cash flows for the first five years.

(ii) Compute changes in net working capital for the first five years.

(iii) Compute NPV based on cash flow from assets for the first five years.

(iv) Should T. Holdings accept the telecommunications project?

Debt-free, Inc., an unlevered firm, is planning to use debt in its capital structure. The firm currently has 5,000 shares outstanding trading at $60 per share. The firm plans to sell 150 6% annual-coupon, 10-year bonds at their face values of $1,000 each and use the proceeds to repurchase some of its shares. When the bonds mature, Debt-free, Inc. plans to reissue new bonds to pay off the principal and to “roll over” its debt this way indefinitely. Assume the firm’s cost of debt does not change and there are no costs of financial distress. Earnings before interest and tax are expected to remain at $28,000 per year forever and the firm has a

dividend policy of paying out all of its earnings. Maureen currently owns 100 shares of Debtfree, Inc.

(a) (i) Calculate the total dollar annual dividend Maureen receives under the firm’s existing capital structure.

(ii) If the market learns of the capital restructuring before the exercise is completed, how many shares are repurchased under the planned capital restructuring?

(iii) Calculate total dollar annual dividend Maureen receives under the firm’s planned capital structure.

(iv) Debt-free, Inc. completes its planned capital restructuring but Maureen prefers the annual dividend payout of the unlevered firm. What is Maureen’s cash flow from homemade leverage by referencing the levered firm’s capital structure and assuming that she can borrow and lend at the same rate as the firm?

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