Applied Corporate Finance - Final Questions Essay

Solutions to Practice Problems by Kyung Hwan Shim University of New South Wales Australian School of Business School of Banking Finance for FINS 3625 S1 2010 May 23, 2010 âˆâ€" These notes are preliminary and under development. They are made available for FINS 3625 S1 2010 students only and may not be distributed or used without the author’s written consent. âˆâ€" 1 Solution for Question 1 Summary Table of Cash Flows t=0 I II CF from Machinery ignoring depreciation Working Capital Level in Working Capital CFs from Working Capital III Revenues Variable Costs Fixed Costs Pre Tax Proï ¬ t Taxes at 34% After Tax Operating CF’s ignoring Deprec. -245,000 160,000 160,000 -160,000 0 0 0 0 0 0 t=1 0 180,000 20,000 -20,000 800,000 450,000†¦show more content†¦Solutions for Question 5 5 Initial Investment Working Capital After Tax Revenue Salvage Value (a) Market value of the levered ï ¬ rm: VL = EL + DL = $100 Ãâ€" 4.5M + $275M = $725M Market value of unlevered ï ¬ rm: VU = EU = $80 Ãâ€" 10M = $800M (b) The levered ï ¬ rm’s stock is a better investment. We can see this from looking at the market value of these two ï ¬ rms. The levered ï ¬ rm is undervalued relative to the unlevered ï ¬ rm. Therefore the levered ï ¬ rms equity is a better investment. (c) What is wrong with these ï ¬ rm values is that the unlevered ï ¬ rm is overvalued relative to the levered ï ¬ rm. Modigliani Miller’s Proposition I states that in a world with no taxes or transactions costs, the value of the ï ¬ rm does not depend on its capital structure. Since the two ï ¬ rms here are identical except for capital structure, they should have the same value. Clearly, we are in a MM world but the ï ¬ rms don’t have the same value. (d) As long as VU = VL , arbitrage opportunities exist. Here, VU VL . This means that the unlevered ï ¬ rm is overvalued and the levered ï ¬ rm is undervalued. So, investors will sell out the unlevered ï ¬ rm and will buy into the levered ï ¬ rm and will earn riskless arbitrage proï ¬ ts by doing so. 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