Should Sophie Pharmaceuticals make the new investment

Reference no: EM132368622

Corporate Finance Questions -

Question 1 - When personal taxes on interest income and bankruptcy costs are considered, the general expression for the value of a levered firm in a world in which the tax rate on equity distribution equals zero is:

V_L = V_U + {1- [(1-t_C)/(1-t_B)]} x B - C(B)

Where

V_L = The value of a levered firm

V_U = The value of an unlevered firm

B = The value of the firm's debt

t_C = The tax rate on corporate income

t_B = the personal tax rate on interest income

C(B) = The present value of the costs of financial distress

a. In their no-tax model, what do Modigliani and Miller assume about t_C, t_B and C(B)? What do these assumptions imply about a firm's optimal debt-equity ratio?

b. In their model with corporate taxes, what do Modigliani and Miller assume about tC , tB and C(B)? What do these assumptions imply about a firm's optimal debt-equity ratio?

c. Consider an all equity firm that is certain to be able to use interest deduction to reduce its corporate tax bill. If the corporate tax is 34 percent, the personal tax rate on interest income is 20 percent, and there are no costs of financial distress, by how much will the value of the firm change if it issues $1 million in debt and uses the proceeds to repurchase equity?

d. Consider another all equity firm that does not pay taxes due to large tax loss carry forwards from previous years. The personal tax rate on interest income is 20 percent, and there are no costs of financial distress. What would be the change in the value of this firm from adding $1 of perpetual debt rather than of $1 equity?

Question 2 - Sophie Pharmaceuticals Ltd has 9.6 million ordinary shares on issue. The current market price is $12.50 per share. However, the company manager knows that the results of some recent drug tests have been remarkably encouraging, so that the 'true' value of the shares is $13. Unfortunately, because of confidential patent issues, Sophie Pharmaceuticals cannot yet announce these test results. In addition, Sophie Pharmaceuticals has a property investment opportunity that requires an outlay of $15 million and has a net present value of $2.5 million. At present, Sophie Pharmaceuticals has little spare cash or marketable assets, so if this investment is to be made it will need to be financed from external sources. The existence of this opportunity is not known to outsiders and is not reflected in the current share price. Should Sophie Pharmaceuticals make the new investment? If so, should the investment be made before or after the share market learns the true value of the company's existing assets? Should the investment be financed by issuing new shares or by issuing new debt?

Question 3 - Overnight Publishing Company (OPC) has $2.5 million in excess cash. The firm plans to use this cash either to retire all of its outstanding debt or to repurchase equity. The firm's debt is held by one institution that is willing to sell it back to OPC for $2.5 million. The institution will not change OPC any transaction costs. Once OPC becomes an all equity firm, it will remain unlevered forever. If OPC does not retire the debt, the company will use the $2.5 million in cash to buy back some of its stock on the open market. Repurchasing stock also has no transaction costs. The company will generate $1,300,000 of annual earnings before interest and taxes in perpetuity regardless of its capital structure. The firm immediately pays out all earnings as dividends at the end of each year. OPC is subject to a corporate tax rate of 35 percent, and the required rate of return on the firm's unlevered equity is 20 percent. The personal tax rate on the interest income is 25 percent, and there are no taxes on equity distribution. Assume there are no bankruptcy costs.

a. What is the value of OPC if it chooses to retire all of its debt and become an unlevered firm?

b. What is the value of OPC if it decides to repurchase stock instead of retiring its debt? (Hint: use the equation for the value of a levered firm with personal tax on interest income from the previous problem.)

c. Assume that expected bankruptcy costs have a present value of $400,000. How does this influence OPC's decision?

Reference no: EM132368622

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