What is the value of the simple option to expand in Section 16-10 if the capacity of the plant is exceeded? Recall that this would be discovered in one year and involve an outlay of $500 million then, with cash inflows of $150 million per year for the following 19 years. The risk-free interest rate is 2% per year. Use Table 17-1, and follow Timothy Luehrman's advice for establishing a value of o. TABLE 17-1 Option Values Multiply the percentage in the table by the share price to get the approximate value of the call option. NPV = Share price + PV of exercise price 10 0.5 0.6 0.7 0.8 0.9 1.1 1.2 1.3 1.4 1.5 2 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 0% 2.60% 9.80% 19% 29% 38.80% 48% 56.50% 2% 5.10% 13.70% 23.60% 33.50% 42.90% 51.70% 59.70% 1% 2.80% 8.20% 12% 17.80% 21.80% 27.70% 31.60% 37.40% 40.90% 46.50% 49.60% 54.80% 57.50% 62.40% 64.60% 5.90% 15.70% 25.60% 35% 44.60% 52.30% 60.20% 69.99% 10% 19.70% 29.20% 38.30% 46.80% 54.70% 61.80% 68.30% 14.70% 23.70% 32.70% 41.20% 49.30% 56.80% 63.60% 68.69% 20% 27.60% 35.90% 44% 51.60% 58.80% 65.30% 71.10% 24.70% 31.30% 39% 46.50% 53.70% 29.40% 34.80% 41.70% 48.80% 55.70% 62.10% 68% 73.40% 33.80% 38% 44.30% 50.90% 57.40% 69.20% 74.40% 50% 51.30% 55% 59.50% 64.50% 69.40% 74% 78.30% 60.50% 66.70% 72.30%
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The cash inflows are $150 million per year for 19 years. We will use the formula for the present value of an annuity: PV = Cash inflow per year * (1 - (1 + interest rate)^-number of years) / interest rate PV = $150 million * (1 - (1 + 0.02)^-19) / 0.02 PV = $150 Show more…
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• Long $20 million of a 6-year inverse floaters with the following quarterly coupon: Coupon at t = 20% - r4(t - 0.25) where r(t) denotes the quarterly compounded, 3-month rate. • Long $20 million of 4-year floating rate bonds with a 45 basis point spread paying semiannually • Short $30 million of a 5-year zero coupon bond You are worried about interest rate volatility. You decided to hedge your portfolio with a 3-year coupon bond paying 4% on a semiannual basis. (1 Point) (a) How much should you go short/long on this bond in order to make it immune to interest rate changes? (b) What is the total value of the portfolio now?
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2. You are the CEO of Underlevered, Inc. and are planning to increase your firm's leverage in a recapitalization by issuing $100 million of debt to be entirely used to buy some of the 100 million outstanding shares of equity. Once executed, this will put your new total amount of debt at $300 million. You have been informed that your firm is so underleveraged that the AAA credit rating of your firm's current debt will remain intact with the additional debt issue, and the firm's stock price will likely increase from its current level of $10 per share. You will make the surprise announcement of the recapitalization May 3rd and will definitely execute the transaction in a month on June 3rd. Also, note that your equity returns are similar to the typical firm: half dividends and half capital gains. The following describes the existing tax code as of May 3rd: • Capital Gains Tax is 20% • top Personal Income Tax is 40% • Corporate Tax Rate is 34% • Your investors typically postpone their capital gains by not selling their shares for years. Assume the implication of this is that the effective capital gains tax rate is cut in half. Nothing else changes for the rest of the month of May. However, the government makes a surprise announcement on June 1st instituting a new tax code with the rates described as follows: • Capital Gains Tax is 15% • top Personal Income Tax is 35% • Corporate Tax Rate is 40% • The government has enacted a law whereby investors must mark-to-market their investment portfolios every year for tax purposes. That is, capital gains taxes can no longer be postponed. Fill in the table below with your estimates of each value at the time noted based on the tax implications of the scheduled recapitalization. Incorporate only the tax effects - ie, ignore agency problems, information asymmetries, and any other possible issues. Also, assume that the new tax code would have no effect on the firm's current stock price were you to not alter the capital structure. As a consequence, when the tax code changes the value of the firm will change in exact accordance to how the Relative Tax Advantage of debt changes. (Show your work for partial credit.)
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