Scribd
Upload
35 views

Session 19 Test

Simac Inc. is a publicly traded company with a current cost of capital of 9%. Its optimal debt ratio is 40%, which gives it a cost of capital of 8%. If it moves to the optimal debt ratio, its firm value would increase by 16.67% based on expected perpetual growth of 2% in free cash flows. Lyric Inc. has stock trading at $20/share and $50 million in debt. If it borrows another $50 million to buy back stock, investors expect the stock price after the buyback to be $22.50/share for the remaining shares. Companies often constrain their bond rating to investment grade (BBB or higher) to limit increased costs of debt,

Uploaded by

Anshik Bansal
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
35 views

Session 19 Test

Simac Inc. is a publicly traded company with a current cost of capital of 9%. Its optimal debt ratio is 40%, which gives it a cost of capital of 8%. If it moves to the optimal debt ratio, its firm value would increase by 16.67% based on expected perpetual growth of 2% in free cash flows. Lyric Inc. has stock trading at $20/share and $50 million in debt. If it borrows another $50 million to buy back stock, investors expect the stock price after the buyback to be $22.50/share for the remaining shares. Companies often constrain their bond rating to investment grade (BBB or higher) to limit increased costs of debt,

Uploaded by

Anshik Bansal
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 3

Session

19: Post Class tests


1. Simac Inc. is a publicly traded company and its current cost of capital is 9%. You
have computed the optimal debt ratio for the firm to be 40% and the cost of
capital at the optimal is 8%. If the firm is mature (with expected free cash flows
growing 2% a year in perpetuity), how much will Simacs firm value increase by,
on a percentage basis, if it moves to its optimal?
a. 11.1%
b. 12.5%
c. 16.67%
d. 25%
e. None of the above
2. Assume that Lyric Inc., a publicly traded company, has 10 million shares, trading
at $20/share and that it has $50 million in debt. You believe that the value of
Lyric will increase by 10% if it borrows $50 million and buys back stock.
Assuming investors are rational, what would you expect to pay, per share, on the
stock buyback?
a. $20/share
b. $21.875/share
c. $22.50/share
d. $23.33/share
e. $25/share
f. None of the above
3. In the last example, assume that you plan to buy the shares back at $25/share. If
you do so, what would you expect the remaining shares in the company to trade
at, after the buy back?
a. $20/share
b. $21.88/share
c. $22.50/share
d. $23.33/share
e. $25/share
f. None of the above
4. One way companies protect themselves from borrowing too much is to put a
constrain the bond rating, i.e., not allow the debt ratio to increase so much that
the rating (synthetic or estimated) drops below the rating constraint. For a non-
financial service company, that rating constraint is often investment grade (BBB).
Which of the following reasons explains this rating constraint?
a. Your access to capital is more limited if you are not investment grade.
b. Your cost of debt can rise significantly once you drop below investment
grade.
c. If your rating drops below investment grade, your customers may hold
back on buying your product or service.
d. If your rating drops below investment grade, suppliers may be less
willing to extend credit (and will demand cash instead)
e. All of the above.

5. Cain & Abel Inc. is in the hotel and entertainment businesses and has an actual
debt ratio of 10%. You have computed an optimal debt ratio of 40% for the firm,
based on its existing operating income, risk and assets. The company is planning
to make investments with the excess debt capacity rather than recapitalize itself
(by buying back stock). Under which of the following scenarios would your
optimal debt ratio remain unchanged?
a. An acquisition of a company in a different business.
b. An expansion of the hotel business
c. An expansion of the entertainment business
d. Expansion of both the hotel and entertainment businesses, in line with
their existing weights in the business
e. None of the above
f. Any of the above

Session 19: Post class test solutions


1. c. 16.67%. To show this, assume that the firm is expected to have $1 in cash flow
next year.
Value at current cost of capital = 1/ (.09-.02) = 14.29
Value at optimal = 1/ (.08-.02) = 16.67
% change in value = (16.67/14.29)-1 = 16.67%
2. c. $22.50/share. If investors are rational, the increase in firm value has to be
spread equally among those who sell their shares back and those who do not.
Increase in value/share = 25/ 10 = $2.50
New stock price = $22.50
Here is a way to confirm that you are right:
Number of shares outstanding after buyback = 10 (50/22.5) = 7.778 million
Value of firm after buyback = 250 + 25 = 275
Value of debt after buyback = 100
Value of equity after buyback 275 -100 = 175
Value per share of remaining shares = 175/ 7.7778 = $22.50
3. b. $21.88. Here is the simplest way to show this:
Number of shares outstanding after buyback = 10 (50/25) = 8 million
Value of firm after buyback = 250 + 25 = 275
Value of debt after buyback = 100
Value of equity after buyback 275 -100 = 175
Value per share of remaining shares = 175/ 8= $21.875
4. e. All of the above. While the costs can vary across companies, dropping below
investment grade can make your indirect bankruptcy costs increase significantly.
5. Expansion of both the hotel and entertainment businesses, in line with
their existing weights in the business. The optimal debt ratio is based on the
existing operating income, risk and assets. Only with a proportional expansion is
there a chance that all three of these will stay stable.

You might also like