Question

1)DBF borrows $[11]B by issuing [4]-year bonds. ECB's cost of debt is [12]%, so it1

will need to pay interest each year for the next [2+B] years, and then repay the principal

$[11]B in year [4]. ECB's marginal tax rate will remain [37]% throughout this

period. By how much does the interest tax shield increase the value of DBF?

NOTE: Provide your answers in Millions. E.G. for 100M you must enter

100.0000, for 20M you must enter 20.000, etc.

2)Axon Industries needs to raise $[67]M for a new investment project. If the firm

issues one-year debt, it may have to pay an interest rate of [13] %, although Axon's

managers believe that [9] % would be a fair rate given the level of risk. If the firm issues

equity, they believe the equity may be underpriced by [15] %.

NOTE: Provide your answers in Millions. E.G. for 100M you must enter

100.0000, for 20M you must enter 20.0000, etc.

a. What is the cost to current shareholders of financing the project out of debt?

b. What is the cost to current shareholders of financing the project out of Equity?

c. What should be the undervaluation of equity to match the cost of debt?

Answer 1

= $11 B X 12% X 37% = $ 0.488 B (1) Interest tax shield in Year 1 Interest tax shield in Year 2 Increase in value of DBF = Debt X Interest X Tax rate = $0.488 B = PV of interest tax shield = 0.488/(1+12%) + 0.488/(1+12%)^2 = $824,744.90 M (2) (a) Cost to current shareholders of financing the project out of debt = $67 MX (1+0.13)=(1+0.09) = $69.46 M (b) Since the equity is underpriced by 15%, thus to raise $67M, the firm has to raise shares that has worth $67M. Let firm issues shares of notional Y That is, Yx (1-0.15) = $67 M Y x 0.85 = $67 M = $67-0.85 = $78.82 M Cost to current shareholders of financing the project out of equity $78,823,529.41 (C) The undervaluation of equity to match the cost of debt 69.46 = 67=(1-2) (1-2) = 67-69.46 = 1-(67-69.46) = 0.035416067 = 3.54%