FM421 - Leverage Benefit From Debt Financing - Accounting & Finance Assignment Help

Assignment Task

Question 1
True/False and Explain:
Leo, a famous financial analyst, says that firms with leverage benefit from debt financing because debt provides a natural tax shield. It follows, therefore, that firm valuations will increase when tax rates increase (all else constant).

Question 2
True/False and Explain:
Yun, a professor of corporate finance, states that venture capitalists often describe their performance in terms of fund IRR’s. However, she claims that funds with high IRR’s don’t necessarily represent better investment opportunities than funds with low IRR’s.

Question 3 
True/False and Explain:
Stav, a well-known equity investor, says that when a firm issues equity to retire its outstanding debt, its share price will decrease.

Question 4
True/False and Explain:
Zhaokailiu, a popular CEO, says that managers will not invest in projects where the weighted average cost of capital is greater than the IRR.

Question 5 
Imagine that you are a venture capitalist at Argiro Ventures evaluating the following startup  idea today (assume today’s date is January 1, 2021). Your fund typically seeks a 25% IRR on  its investments. The startup requires 4 rounds of financing over the next 7 years: $2 million  today, $1 million in two years, $1 million in 3 years, and $3 million in 7 years. If the company  has an IPO at the end of 10 years, the company will be worth $1.5 billion; the probability of  an IPO is 10%. Otherwise, if the company is acquired by another company in 10 years (which  happens with 25% probability), the expected acquisition value will be $1 billion. If the  company does not get acquired, it will be worth 0. The founders of the company initially  allocate 1,000,000 shares to themselves, and decide keep 350,000 shares in reserve in case  they wish to hire any additional employees in the future.  
a) Please provide the share price of the startup in each round of financing and the  number of shares issued to investors in each round.  
b) How do your answers to part a) change if the probability of acquisition is only 15%  (assume all other information in the problem stays the same)? Please provide one  sentence explaining intuition for how the results change.  
c) Suppose the founders wish to understand how potential changes in the investment  amounts would impact the share price in each round. If the share price in round 2  were to increase by 10%, due to a change of x% in the investment amount in the third  year, what would x be? (assume all other information in the problems stays the same  as originally posed, so the probability of acquisition is 25%. Also assume that the  number of new shares issued to investors at time 0 stays the same as what you  calculated in part a). If you are unable to answer this question, please explain why.
 

Question 6
Today is January 1, 2021. You are helping Felix make 10-year cash flow projections for a  project in the electronics industry. The cost of financing for the project can be inferred from  the following data. Analysts estimate that the typical cost of debt for electronics projects is  approximately 5.1%. The projected beta of equity for the project is 1.20, and the firm is  planning to maintain a constant debt-to-equity ratio (in market values) of 0.40. Using expert  forecasts for stock market returns, you believe that the annual expected return for the entire  market will be 8% for the next 10 years, and that the risk-free rate will be projected to remain  at 4.5% over the entire life of the project. Assume a marginal tax rate of 25%, and that any  tax loss can be carried forward indefinitely.  
The project will have various investment needs. For example, the machinery needed for the  project costs $3 million, and according to the tax authority, is depreciated using the straight  line method over ten years. You can operate the machinery for 10 years. The pre-tax salvage  value of the machinery at the end of the 10 years is expected to be $300,000. The purchase  of the machinery is made today. You also expect to incur additional capital expenditures of  $1.4 million for new computer equipment on December 31, 2027. This equipment is  depreciated using the straight line method over the remaining life of the project, and is not  expected to have any salvage value. The revenues from the project are expected to be $20  million first starting on December 31, 2021, and are expected to grow at a rate of 2.5% per  year. Labor is expected to cost approximately $1.2 million every year, while COGS are  estimated to be 15% of revenues each year. 
The net working capital required for the project is given by the following data: Days sales  outstanding will be 30 days (out of a 360 day cycle) and based entirely on annual revenues,  while days payable outstanding will be 45 days (out of a 360 day cycle), and will only be  relevant for labor costs (not for COGS or any other expenses). Inventory will be 7% of COGS  each year. Assume net working capital is 0 as of today, and fully recovered by the end of the  project (on December 31, 2030).  
a) Please forecast the free cash flows for the project.  
b) Please calculate the weighted average cost of capital for the project.  c) Suppose free cash flow were to increase by 15% at the end of the first year (i.e.  December 31, 2021) because of an x% increase in revenues. Assume all other  information in the problem remains the same (so Accounts Receivables will be based  on the new revenues). Please solve for x
 

Question 7
Qibei Dumplings is a famous dim sum restaurant chain. The company has total debt outstanding of 300 million dollars, and the cost of debt is 4%. The debt interest payments are perpetual, and have a beta of 0. The firm’s perpetual EBIT is 70 million dollars, its assets are fully depreciated, and the tax rate is 30%. Qibei Dumplings’ current value of equity is 400 million dollars. The firm’s next cash flow will occur at the end of the year. The expected market return every year is 10%. Compute the equity beta for this firm. If there is not enough information to calculate this value, please explain why, and describe the information you would need in order to calculate this value.

Question 8
You are considering setting up a firm, called Maximilian Inc., to produce gadgets. The demand for gadgets can be high, medium, or low with equal probability. The corresponding cash flows associated with each type of demand are the following:
Demand             Annual Cash Flows
High                   600
Medium              0
Low                  -600

These cash flows will begin one year after the investment is made and continue forever. The cost of the project is $300 today. The discount rate is 50% (very high!).
a) What is the NPV of the project?
b) Suppose you can commission a study that tells you what the demand for gadgets will be. The study takes two years to complete. What is the NPV of the project if you commission the study?
c) Suppose that you can commission a different type of study that takes only one year tocomplete. The drawback of this type of study is that the information is less precise than inpart b). The result of the study will be either “positive” or “negative” withequal probability.When the result is positive, demand will be high with probability 2/3 and medium withprobability 1/3 (and thus low with probability zero). When the result is negative, demand willbe low with probability 2/3 and medium with probability 1/3. What is the NPV of the project if you commission this type of study?

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