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Debt to Equity ℎℎ ′ 9,771+1,885 Dividend Payout Inventory Turnover = 0.069 Working backwards from the income tax expense, we estimate income tax rate to be 34%. NOPAT is then Operating profit taxes, or 3,137*(1-0.34) = 0.319 Average

The firm has decided to increase the debt finance component portion from 20% to 30% which is a good decision since the interest payments are 100% tax deductible. The appropriate capital structure would be to

1. How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these anticipated uses affect the calculations?

Middlesex Plastics Manufacturing had 2011 Net Income of $15.0 Million. Its 2012 Net Income is forecast to increase by 8%. The company’s capital structure has been 35% Debt and 65% Equity since 2010, and the company plans to maintain this capital structure in 2012. The company paid $3.0 Million cash dividends in 2011. The company is planning to invest in a major capital project in 2012. The capital budget for this project is $12.0 Million in 2012.

Use the following information for questions 13-16. You are looking at purchasing a widget producing machine that will cost $11 million which will be salvageable in 9 years for $3 million. The machine will increase revenues by $7.5 million per year and will fall into the 30% CCA bracket. You can lease the machine for $2.75 million per year. Your pre-tax cost of debt is 8.5%. Your corporate tax rate is 35%.

It can be used to pay the dividends, no matter the preferred dividend and common dividends. So the company need enough retaining earnings to pay these dividends to let the shareholders invest in the company. So there will be a retaining earnings.

d) Calculate the new value per share after the capital structure change. (Hint: use your answers to parts b and c.)

Based on your analysis above, make at least two (2) recommendations as to how each company could improve its working capital positions. Provide support for your recommendations.

Cost of Equity = Risk free rate + (Market return – risk free rate) X beta

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

iii. Prepare a basic discounted cash flow analysis; i.e. compute incremental cash flows and a terminal value, and discount them at a weighted average cost of capital. Can you do a multiples-type analysis here as well?

a. What risk-free rate and risk premium did you use in calculating the cost of equity for each division? Why did you choose these numbers?

Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at $1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = $1,100 – 0 = $1,100 c. Use the

(Note: retained earnings information is irrelevant here) Part b. Total market value = debt + pref. equity + Common equity = 1,147,200 + 1,250,000 + 2,500,000 = $4,897,200

Finally, we come up with the value for the operating after-tax operating cash flows for the next three years and the terminal value. We calculate the present value of these cash flows by discounting by the unlevered cost of capital, rU given as 8.7%, which gives us a value of the unlevered firm of ca. $566m.