Actuarial Outpost
 
Go Back   Actuarial Outpost > Exams - Please Limit Discussion to Exam-Related Topics > SoA/CAS Preliminary Exams > Investment / Financial Markets
FlashChat Actuarial Discussion Preliminary Exams CAS/SOA Exams Cyberchat Around the World Suggestions

DW Simpson Global Actuarial & Analytics Recruitment
Download our 2017 Actuarial Salary Survey
now with state-by-state salary information!


Investment / Financial Markets Old Exam MFE Forum

Reply
 
Thread Tools Search this Thread Display Modes
  #1  
Old 02-13-2019, 02:42 AM
dws098 dws098 is offline
Non-Actuary
 
Join Date: Nov 2018
Posts: 3
Default Corporate finance question - refinancing with tax shield

This comes from Corporate Finance (Berk/Demarzo/Strangeland), the recommended study text:

Richmond Industries plans to issue 1.5 million new shares of equity to raise $50 million to finance a new investment. After making the investment, Richmond expects to earn free cash flows of $10 million each year. Richmond currently has 5 million shares outstanding, and it has no other assets or opportunities. Suppose the appropriate discount rate for Richmondís future free cash flows is 8%, and the only capital market imperfections are corporate taxes and financial distress costs.

a. What is the NPV of Richmondís investment?

b. What is Richmondís share price today?

Suppose Richmond borrows the $50 million instead and thus there are only 3.5 million shares outstanding. The firm will pay interest only on this loan each year, and it will maintain an outstanding balance of $50 million on the loan. Suppose that Richmondís corporate tax rate is 40%, and expected free cash flows are still $10 million each year.

c. What is Richmondís share price today if the investment is financed with debt?

__________________________________________________ ____

a is pretty straightforward. It's just -50 + 10/0.08 = 75 million (present value of perpetuity less initial investment). For b, you divide 75 million by 5 million to get $15/share.

I'm having trouble with c. I get that the leveraged value of the firm should be the unleveraged value plus the tax shield. So I add 75 + 0.4 * 50 = 95 million. To get the share price, we subtract the debt from the leveraged value to get the equity, then divide by the number of shares. This gives (95 - 50)/3.5 = $12.86/share. But it's my understanding that (when there's a tax shield involved) the share price is supposed to go up when debt is increased.

In the solutions manual, the solution is (75+0.4 * 50)/5 = $19 per share. This makes no sense to me, as there are only 3.5 million shares in the leverage scenario (not 5 million).

Where am I going wrong?
Reply With Quote
  #2  
Old 02-13-2019, 11:36 AM
Alpha12 Alpha12 is offline
Member
CAS Non-Actuary
 
Join Date: Apr 2002
Studying for IFM
Posts: 690
Default

I get the same answer as you, 12.86/ share.
Reply With Quote
Reply

Thread Tools Search this Thread
Search this Thread:

Advanced Search
Display Modes

Posting Rules
You may not post new threads
You may not post replies
You may not post attachments
You may not edit your posts

BB code is On
Smilies are On
[IMG] code is On
HTML code is Off


All times are GMT -4. The time now is 06:48 AM.


Powered by vBulletin®
Copyright ©2000 - 2019, Jelsoft Enterprises Ltd.
*PLEASE NOTE: Posts are not checked for accuracy, and do not
represent the views of the Actuarial Outpost or its sponsors.
Page generated in 0.11814 seconds with 9 queries