Financial Questions for Investment Analysis

Consider the table below that sets out data on the Carpe Vinum Company's balance sheet (CV Co).

The investment project has an investment cost of £70m and a present value of x, distributed uniformly between £50m and £200m. CV Co makes the investment decision after it knows the realization of the present value x. The market is risk-neutral and has a discount rate of zero.

1. What is the value of the firm, the debt, and the equity with the information given? Assume that no renegotiation of the debt contract is possible.

1. Suppose the firm could replace its debt liability with a new debt contract with face value D. What value of D maximizes the value of the debt? What is the value of the debt in this case? Assume that no renegotiation of the debt contract is possible.        

1. Now suppose the firm could renegotiate the debt contract free of cost after the parties observe the realization value of x. What is the value of the firm in this case? It does not matter to your answer whether the debt has a face value of £50m or face value D.

1. Now suppose the firm could renegotiate the debt contract free of cost only before the parties know the realization value of x. What is the value of the firm in this case? Assume that no debt renegotiation can happen after the parties see the realization value of x.

Alea Iacta Company (AI Co), a company specializing in high-tech technology, considers investing in a new project that requires an investment cost of £100m. AI Co’s existing assets have a payoff of £500m with probability ? and zero with probability 1-?. The new investment will increase the probability of a payoff of £500m by 30%. The firm has no other assets than their existing fixed assets, so it requires new capital to cover the entire investment cost of £100m. The investors do not know ? for sure, but they think it is equally likely that the probability is 30% and 50%. The company knows the probability ? perfectly. The discount rate is zero, and the market is risk-neutral. Assume that the firm can only use debt and equity to fund the investment, which implies that the investors’ return depends only on the company's payoff.

1. As perceived by the investors, how valuable is the new investment AI Co is planning?
2. Explain what we mean by pooling and separating equilibria in this context.
3. Can you find a pooling equilibrium where the firm invests?
4. Can you find a separating equilibrium where the firm invests?

ABC Corp. maintains a debt-equity ratio of 0.75, and has an equity cost of capital of 15%, and a debt cost of capital of 5%. ABC’s corporate tax rate is 35%, and its market value of equity is $300 million. 

1. If ABC’s free cash flow is expected to be $20 million in one year, what constant expected future growth rate is consistent with the firm’s current market value?

1. Estimate the value of ABC’s interest tax shield.

1. ABC Corp. has decided on a 20% stock dividend. If the firm currently has 900,000 shares outstanding, how many shares will be outstanding after the stock split? 

Suppose XYZ Corp. has an equity cost of capital of 10%, market value of equity $10.8 billion, and market value of debt $3.6 billion. Suppose XYZ’s debt cost of capital is 6.1% and its marginal tax rate is 35%.

1. What is XYZ’s WACC?      
2. If XYZ maintains a constant debt-equity ratio, what is the value of a project with average risk and the following expected free cash flows?

Year                       0                 1              2              3

3.If XYZ maintains its debt-equity ratio, what is the debt capacity of the project in part b?