Question #1.
Canada Telecom, a telephone company, is contemplating investing in a project in multimedia applications. The company is currently 30% debt financed. The company’s analysts have estimated the project’s cash flows but need to determine the project cost of capital. Canada Telecom analysts assess that their new multimedia division has a target debt-equity ratio of 0.6, and a cost of debt of 6.5%. In addition, the risk-free rate is 3%, and market risk premium is 5%.
XYZ Co. is a pure play in the multimedia business and is 35% debt financed. Its current equity beta is 1.05. Assume that both Canada Telecom and XYZ have a tax rate of 35%, and a debt beta of 0.
(1) Is Canada Telecom’s WACC the right discount rate for its new project? Why or why not? (5 marks)
(2) Explain why you cannot use XYZ’s equity beta XXXXXXXXXXas a proxy for the equity beta of Canada Telecom’s new project. Estimate the new project’s equity beta. (10 marks)
(3) What is the new project’s cost of capital? (5 marks)
Question #2.
In March 2020, Snow Fun, Inc., made a rights issue at a subscription price of $10 a share. One new share can be purchased for every 3 shares held. Before the issue, there were 12 million shares outstanding, and the share price was $15.
(1) What is the total amount of new money raised? (2 marks)
(2) What is the expected stock price after the rights are issued? Why is the stock price expected to fall after the right issue? (10 marks)
(3) Suppose that the company had decided to issue the new stock at $8 instead of $10 a share, how many new shares would it have needed to raise the same sum of money? Show that Snow Fun’s shareholders are just as well off if it issues the shares at $8 a share rather than $10. (8 marks)
Question #3.
Windsor, Inc. is currently an all-equity financed firm, and its cost of equity is 12%. It has 20,000 shares outstanding that sell for $25 each. The firm contemplates a restructuring that would borrow $100,000 in perpetual debt at an interest rate of 8% which will be used to repurchase stock. Assume that the corporate tax rate is 35%.
(1) Calculate the present value of the interest tax shields and the value of the firm after the proposed restructuring. (8 marks)
(2) What will be shareholders’ required rate of return after the proposed restructuring? Is it higher or lower than 12%? Why or why not? (12 marks)
Question #4.
State the dividend irrelevance proposition. What are the assumptions behind this proposition? Explain why this proposition does not hold in the real world. (20 marks)
Question #5.
After studying Chapter 26, we understand that futures and forwards can be used to reduce risk. What are the differences between futures and forwards? (12 marks)
A Canadian firm will have to pay US $1 million six months from now for the goods purchased from a US company. In light of the COVID-19 pandemic, the company is concerned about potential increases in the value of the US dollar in the future. How could this firm hedge against this risk with forwards? (8 marks)
Forward contract quotations (CAD/USD)
| period | price |
| 1 month | 1.37374 |
| 3 month | 1.37510 |
| 6 month | 1.37765 |
| 9 month | 1.38052 |