Concept explainers
Info Systems Technology (IST) manufactures microprocessor chips for use in appliances and other applications. IST has no debt and 100 million shares outstanding. The correct price for these shares is either $14.50 or $12.50 per share. Investors view both possibilities as equally likely, so the shares currently trade for $13.50. IST must raise $500 million to build a new production facility. Because the firm would suffer a large loss of both customers and engineering talent in the event of
- a. Suppose that if IST issues equity, the share price will remain $13.50. To maximize the long-term share price of the firm once its true value is known, would managers choose to issue equity or borrow the $500 million if
- i. They know the correct value of the shares is $12.50?
- ii. They know the correct value of the shares is $14.50?
- b. Given your answer to part (a), what should investors conclude if IST issues equity? What will happen to the share price?
- c. Given your answer to part (a), what should investors conclude if IST issues debt? What will happen to the share price in that case?
- d. How would your answers change if there were no distress costs, but only tax benefits of leverage?
Want to see the full answer?
Check out a sample textbook solutionChapter 16 Solutions
Corporate Finance (4th Edition) (Pearson Series in Finance) - Standalone book
Additional Business Textbook Solutions
Principles of Managerial Finance (14th Edition) (Pearson Series in Finance)
Gitman: Principl Manageri Finance_15 (15th Edition) (What's New in Finance)
Foundations of Finance (9th Edition) (Pearson Series in Finance)
Foundations Of Finance
Marketing: An Introduction (12th Edition)
Horngren's Financial & Managerial Accounting, The Financial Chapters (Book & Access Card)
- ABC Industries is considering an investment that requires the company to issue new equity. The project will cost $100M but will add $120M to the company’s value after it is completed. The company’s true value absent the new project is $1B. Management knows this true value, but outside investors mistakenly value the company at $600M absent the project. Investors are aware of the project and correctly forecast that it will add $120M to the company’s value. The company has no cash, and if it wants to invest in the project, it must issue equity. Now assume that the market will soon learn the true value of the company. However, the company cannot wait to invest in the project. If it does not invest now, then it will lose access to the project. What will the company’s stock price be once the market learns the company’s true value if the company issued equity and invested in the project? What will the company’s stock price be once the market learns the true value if the company passed up…arrow_forwardThe Wrought Sisters Company (WSC) produces foam model airplanes for the hobby industry. WSC has managed to be debt free to date. There are 100,000 ordinary shares outstanding, with a market capitalization of $2 million. Equity holders require a return of 10 percent on their investment. WSC intends to diversify by manufacturing a new line of balsa wood model airplanes. This venture will not raise the risk level of the company. The equipment to make such airplanes cost $12,000, which will be the depreciable base. WSC uses straight-line depreciation for its non-current assets. The equipment is expected to last 3 years, at which time the equipment will be sold for $2,000 (after tax). The expected demand is 1,000 balsa airplanes per year. Each new airplane will be priced at $20 in the first year and thereafter rise at 5 percent per year. Total variable costs are expected to be $4 per airplane. The corporate tax is at 15 percent. REQUIRED : What is the price per share of…arrow_forwardThe Grail Segament (GS) produces foam model airplanes for the hobby industry. GS has managed to be debt free to date. There are 100,000 ordinary shares outstanding, with a market capitalization of $2 million. Equity holders require a return of 10 percent on their investment. GS intends to diversify by manufacturing a new line of balsa wood model airplanes. This venture will not raise the risk level of the company. The equipment to make such airplanes cost $12,000, which will be the depreciable base. GS uses straight-line depreciation for its non-current assets. The equipment is expected to last 3 years, at which time the equipment will be sold for $2,000 (after tax). The expected demand is 1,000 balsa airplanes per year. Each new airplane will be priced at $20 in the first year and thereafter rise at 5 percent per year. Total variable costs are expected to be $4 per airplane. The corporate tax is at 15 percent. Question: Please compute the value added to the…arrow_forward
- Systems has 6.45 billion shares outstanding and a share price of $17.25. Quisco is considering developing a new networking product in-house at a cost of $497 million. Alternatively, Quisco can acquire a firm that already has the technology for $899 million worth (at the current price) of Quisco stock. Suppose that absent the expense of the new technology, Quisco will have EPS of $0.828. a. Suppose Quisco develops the product in-house. What impact would the development cost have onQuisco's EPS? Assume all costs are incurred this year and are treated as an R&D expense, Quisco's tax rate is 40 %, and the number of shares outstanding is unchanged. b. Suppose Quisco does not develop the product in-house but instead acquires the technology. What effect would the acquisition have on Quisco's EPS this year? (Note that acquisition expenses do not appear directly on the income statement. Assume the firm was acquired at the start of the year and has no revenues or expenses of its own, so that the…arrow_forwardQuisco Systems has 7.1 billion shares outstanding and a share price of $17.79. Quisco is considering developing a new networking product in house at a cost of $532 million. Alternatively, Quisco can acquire a firm that already has the technology for $901 million worth (at the current price) of Quisco stock. Suppose that absent the expense of the new technology, Quisco will have EPS of $0.66. a. Suppose Quisco develops the product in house. What impact would the development cost have on Quisco's EPS? Assume all costs are incurred this year and are treated as an R&D expense, Quisco's tax rate is 25%, and the number of shares outstanding is unchanged. b. Suppose Quisco does not develop the product in house but instead acquires the technology. What effect would the acquisition have on Quisco's EPS this year? (Note that acquisition expenses do not appear directly on the income statement. Assume the firm was acquired at the start of the year and has no revenues or expenses of its own, so…arrow_forwardFountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the firm’s only activity and that the firm will close one year from today. The company is obligated to make a $5,300 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects: Economy Probability Low-Volatility Project Payoff High-Volatility Project Payoff Bad .50 $ 5,300 $ 4,700 Good .50 6,400 7,000 a. What is the expected value of the company if the low-volatility project is undertaken? The high-volatility project? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.) b. What is the expected value of the…arrow_forward
- A corporation is trying to decide whether to buy the patent for a productdesigned by another company. The decision to buy will require an investment of $8 million, and the demand for the product is not known. If demand is light, the company expects a return of $1.3 million each year for three years. If the demand is moderate, the return will be $2.5 million each year for four years, and high demand will mean a return of $4 million each year for four years. It is estimated that the probability of high demand is 0.4 and the probability of a light demand is 0.2. The firm's interest rate (risk-free) is 12%. Calculate the expected present worth of the investment. On this basis, should the company make the investment? (All figures represent after-tax values.)arrow_forwardeEgg is considering the purchase of a new distributed network computer system to help handle its warehouse inventories. The system costs $50,000 to purchase and install and $32,000 to operate each year. The system is estimated to be useful for 4 years. Management expects the new system to reduce the cost of managing inventories by $58,000 per year. The firm’s cost of capital (discount rate) is 11%. a.The firm is not yet profitable and therefore pays no income taxes. b.The firm is in the 26% income tax bracket and uses straight-line (SLN) depreciation with no salvage value. Assume MACRS rules do not apply. c. The firm is in the 26% income tax bracket and uses double-declining-balance (DDB) depreciation with no salvage value. Given a four-year life, the DDB depreciation rate is 50% (i.e., 2 × 25%). In year four, record depreciation expense as the net book value (NBV) of the asset at the start of the year. 1. What is the internal rate of return (IRR) of the proposed investment for…arrow_forwardFountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the firm’s only activity and that the firm will close one year from today. The company is obligated to make a $4,200 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects: Economy Probability Low-Volatility Project Payoff High-Volatility Project Payoff Bad .50 $ 4,200 $ 3,400 Good .50 4,600 4,900 a. What is the expected value of the company if the low-volatility project is undertaken? What if the high-volatility project is undertaken? (Do not round intermediate calculations.) b. What is the expected value of the company’s equity if the low-volatility…arrow_forward
- J&R Construction Company is an international conglomerate with a real estate division that owns the right to erect an office building on a parcel of land in downtown Sacramento over the next year. This building would cost $61 million to construct. Due to low demand for office space in the downtown area, such a building is worth approximately $59 million today. If demand increases, the building would be worth $63.4 million a year from today. If demand decreases, the same office building would be worth only $57 million in a year. The company can borrow and lend at the risk-free annual effective rate of 2 percent. A local competitor in the real estate business has recently offered $760,000 for the right to build an office building on the land. What is the value of the office building today? Use the two-state model to value the real option. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)…arrow_forwardBakers Industries believes that its two primary product lines, pastries and savory food, are rapidly becoming outdated. Its free cash flow is rapidly diminishing as it loses market share to new firms entering its industry. Bakers Industries has OMR 375 million in debt outstanding. Senior management expects the pastries and savory food product lines to generate OMR 48 million and OMR 29 million, respectively, in earnings before interest, taxes, depreciation, and amortization next year. Senior management also believes that they will not be able to upgrade these product lines due to declining cash flow and excessive current leverage. A competitor to its pastries business last year sold for 19 times EBITDA. Moreover, a company that is similar to its savory food product line sold last month for 22 times EBITDA. Estimate Baker's breakup value before taxes.arrow_forwardJ&R Construction Company is an international conglomerate with a real estate division that owns the right to erect an office building on a parcel of land in down- town Sacramento over the next year. This building would cost $65 million to construct. Due to low demand for office space in the downtown area, such a building is worth approximately $58.7 million today. If demand increases, the building would be worth $70.4 million a year from today. If demand decreases, the same office building would be worth only $55.2 million in a year. The company can borrow and lend at the risk-free annual effective rate of 4.8 percent. A local competitor in the real estate business has recently offered $1.8 million for the right to build an office building on the land. Should the company accept this offer? Use a two-state model to value the real option.arrow_forward
- EBK CONTEMPORARY FINANCIAL MANAGEMENTFinanceISBN:9781337514835Author:MOYERPublisher:CENGAGE LEARNING - CONSIGNMENTIntermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning