Homework 2 Solution, Fin 500Q, Quantitative Risk Management 1. Assume gold price risk is diversifiable, and the riskless rate is 5%. A firm produces a unit of gold a year from today. Assume all interest is compounded annually and is tax deductible. The price of gold is either $500 or $200, each with probability 0.5. Suppose the firm pays taxes at a rate of 40% for all its cash flow in excess of $300. The value of the firm is the expected discounted value of its cash flow less the expected discounted value of bankruptcy costs and taxes that it pays. The firm can hedge by buying/selling forward contracts on gold. Start by assuming that bankruptcy costs are zero. (a) Find the value of the unhedged unlevered firm. (10 points) Answer: 1 · [350 − 0.5 · …show more content…
If it did not take the gamble the shareholders value would be zero. So shareholders would take the gamble. If the value of the firm rises to 500, and it does not take the gamble, the value of the shareholders would be 500 − 250 · (1.456) − .4 · (200 − 250 · .456) = 101.6. If they took the gamble, then because they will be able to pay back the debt whether they win or lose the gamble. Therefore, their value with the gamble would be 101.6 - 14.9 = 86.7, so they would not take the gamble. The key intuition is simply that now they get both the gain and the loss from the gamble, while when the initial value was 200, the shareholders only got the gain from the gamble. The value of the firm is now Value of Firm = 1 [.5 · [.995 · 160 + .005 · (1200 − .4 · (900 − 250 · .456))] + .5 · (500 − .4 · (200 − 250 · .456))] 1.05
= 299.629. Notice, that the value of the firm with debt overhang is lower than the same problem without debt overhang in part (e). (h) Suppose the firm were to hedge. Would equity holders take the gamble and what would be the value of the firm? (10 points) Answer: If the firm were to hedge by selling gold in a forward contract, it would get a sure cash flow of $350. Then it would not not take the gamble, because even if it lost, it could still make the debt payment of 250 · (1.05) = 262.5 and taxes of .4(50 − 250 · .05) = 15 (we assume the debt is safe, and therefore has a yield of 0.05, and verify that it can make the payment).
(d) $1 billion 10 year debenture @ 7.5% with 18.18 warrants at $ 55 exercisable until 1988.
The fixed cost is assumed that Larry has discovered the other fixed cost incurred. The total investment is $800,000. The worst case scenario assumes that Larry got a total line of credit from the bank in the amount of $400,000 and invested $400,000 from other source. The Notes payable – short term and the long-term debt is (11.8 + 3.7) = 15.5 % from Table F in the handout. The Loan interest and payment per year is ($400,000 * 0.155)= $62,000. The Income data from Table F indicates that there is a 0.4% of all other expenses net out of the total sales which equals to $109,908 (5,700,666 gallons * $4.82 *0.4%) .
9. What is the Cost of Debt, before and after taxes? Using the interest rate for the largest debt…cannot use the weighted interest rate for the debt since it includes capital lease obligations with no stated rate and could not find in the notes to the financials. 5.4% After tax cost is .054 x (1-.36) = 3.5%
- The Bet-r-Bilt Company has a 5-year bond outstanding with a 4.30 percent coupon. Interest payments are paid semi-annually. The face amount of the bond is $1,000. This bond is currently selling for 93 percent of its face value. What is the company's pre-tax cost of debt?
Facts: Five years ago, Lacey, Kaylee, and Doug organized a software corporation, DLK, which develops and sells Online Meetings software for businesses. DLK is a C corporation and each individual contributed $10,000 to the company in exchange for 1,000 shares of DLK stock (for a total of 3,000 shares). The corporation also borrowed $250,000 from ACME Venture Capital to finance operating costs and capital expenditures. It was suggested by Lacey that Kaylee and Doug (original investors) contribute an additional $25,000 to DLK in exchange for five 20-year debentures. The debentures will be unsecured and subordinate to ACME’s debt. Annual
Shareholder’s equity would be lower than that shown in 1982 ($318,000) because the company has to pay off interest and principal for many loans. There will be little money left for shareholder’s equity.
1. All of the following are the general principles underlying the valuation of liabilities e xcept:
2. Forecast the firm’s financial statements for 2002 and 2003. What will be the external financing requirements of the firm in those years? Can the firm repay its loan within a reasonable period? In order to forecast the financial statements of 2002 and 2003, the following assumptions need to be made. The growth of sales is 15%, same as 2001, which is estimated by managers. The rate of production costs and expenses per sales is constant to 50%. Administration and selling expenses is the average of last 4 years. The depreciation is $7.8 million per year, which is calculated by $54.6 million divided by 7 years. Tax rate is 24.5%, which is provided. The dividend is $2 million per year only when the company makes profits. Therefore, we assume that there will be no dividend in 2003. Gross PPE will be $27.3 million (54.6/2) per year. We also assume there is no more long term debt, because any funds need in the case are short term debt, it keeps at $18.2 million. According to the forecast, Star River needs external financing approximately $94 million and $107 million in 2002 and 2003, respectively. In order to analysis if the company can repay the debt, we need to know the interest coverage ratio, current ratio and D/E ratio. The interest coverage ratios through the forecast were 1.23 and 0.87 respectively, which is the danger signal to the managers, because in 2003, the profits even not
Calculate the after tax cost of debt using the following information (hint: see page 285 in text).
OCC and OCP together invested $750,000 into Dogloo in the form of subordinated debenture with 13% interest rate, which guarantees them stable interest cash inflows each year (Exhibit 4). The two investors’ combined ownership interest will be 0.5% of the Dogloo’s equity value because the company’s equity valuation is $213 million, exceeding $80 million; this will be the cash inflow at exit for the investors. Through calculation, the required equity value at exit is $238 million if the investors have an estimated IRR of 25% (Exhibit 4).
The Standard Oil Company of California(Socal) is trying to determine how much to bid on the Gulf Oil Corporation. George Keller, the CEO of Socal, would need to borrow 14 billion dollars in order to make a substantial bid. While banks are willing to lend the money because of Socal's low to debt ratio, the loan would put the company in a highly leveraged position. In order to alleviate that debt, some of Gulf's assets could be sold. Keller has to consider the value of Gulf's exploration and development program when calculating future returns. Two billion dollars were being spent on the exploration and development program. This money could instead be used to reduce the debt if Socal acquired the company. However, the exploration program
The market value of debt was calculated using the existing yield of maturity on a 5 yar bond issued on a private placement basis on July 1, 2000. With the coupon of 5.75% and the discount price of 97, YTM for this bond is 6.62%. With a discount price being 97, the market value of debt is 17,654M.
Of the many risk profiles that exist, namely: cash profile, conservative profile, moderately conservative profile, growth profile, and high growth profile, I would settle on balanced profile in allocating assets because an investor would want to steadily grow his investment over time (Bailey & Kinerson, 2005). I will be comfortable taking on a greater level of risk to achieve this. With the balanced profile I will be capable of placing more of my investments into growth assets. This will increase the possibility of rises and falls to my investment value. The possibility of a negative return would be very remote with the balanced profile. This type of asset allocation creates a balance between seeking capital for growth and wealth preservation (Bailey & Kinerson, 2005). With the balanced risk profile, an investor accepts the risk in the pursuit of long term gain. With the balanced risk profile an investor seeks reasonable level of returns and accepts a medium level of risk. This kind of asset allocation makes an investor to accept the possibility of losses from time to time while he expects growth in assets over the medium to longer term (Bailey & Kinerson, 2005). With a balanced risk profile an investor will have a balanced allocation between stable "income" investment assets such as cash and fixed interest and their allocation to more volatile growth investments such as shares and property (Bailey & Kinerson, 2005). Balanced risk profile is suitable
At one point or another odds are that individuals have thoughts about that one investment that will make them rich quick. Then the reality of it all sinks in and thoughts of getting rich quick are instead replaced with concerns about the potential possibility that the investment could yield one losing everything or even just the uncertainty of it all. There is a name for this in the finance investment world and it is called; risk. Authors Besley & Brigham of the text book CFIN 4, 4th Edition explain, “Although most people view risk as a chance of loss, in reality risk occurs any time we cannot be certain about the future outcome of a particular activity or event. Consequently, risk results from the fact that an action such as investing can produce more than one outcome in the future.” (Besley & Brigham, 2016, pg. 126). When it comes to investing and the level of risk associated, an individual should know as much as possible about that investment and if one is unable to obtain such information, it should be carefully considered to determine if the investment is worth the risk, as illustrated in the below scenario.
Probabilistic risk analysis is becoming more and more important in long-term damage estimation for structure.