CHAPTER 22 HOMEWORK

22-1) Valdell's free cash flow (FCF) is $2 million per year and is expected to grow at a constant rate of
5% a year; its beta is 1.4. What is the value of Vandell's operations? If Vandell has $10.82 million in
debt, what is the current value of Vandell's stock? (Hint: Use the corporate valuation model from
Chapter 7).

1 million shares
30 % debt
Interest Rate 8%
RFR 5%
Market Premium 6%
40% tax rate

The first thing we need to figure out is the Vandell's WACC. Knowing all of our inputs
for the debt portion already, let's start with the cost of equity

We know from previous discussions & our Case #3 that our cost of equity is equal to the RFR + Market Premium * Be

Rfr 5%
Rp 6%
Beta 1.4

Cost of equity 13.4%

The WACC is fairly straightforward from here. We know our weighted averaged so we can figure
out the rest

Weight of debt 0.3

Weight of equity 0.7
Interest rate of debt 8%
Tax rate 40%
Rate of equity 13.4%

WACC 10.82%

So far so good. Recall from chapter 7 that our next step is to figure out the value of our operations.
for constant growth model. This calculation is as follows:

Vops = FCF (1+g) / WACC - g

This is fairly easy and is as follows

FCF $2
g 5%
WACC 10.82%

Vops $ 36.08 million

That is the value of our operations prior to considering the debt. Now all we have to do is subtract
the debt from our value of operations and divide by the number of shares to find the per stock value of the compan

Vops $ 36.08 million

Debt $ 10.82 million
Value per share $ 25.26 million
Total shares 1 million

Value per share $ 25.26

 tant rate of
10.82 million in
n model from

o the RFR + Market Premium * Beta

e can figure

our operations.
 do is subtract
e per stock value of the company
CHAPTER 22 HOMEWORK

22-2) Hastings estimates that if it acquires Vandell, interest payments will be $1.5 million per year for
3 years, after which the current target capital structure of 30% debt will be maintained. Interest in
the fourth year will be $1.472 million, after which interest and the tax shield will grow by 5%. Synergies
will cause the free cash flows to be $2.5 million, $2.9 million, $3.4 million, and $3.57 million in Years
1 through 4, respectively, after which the free cash flows will grow at a 5% rate. What is the unlevered
value of Vandell, and what is the value of its tax shields? What is the per share value of Vandell to
Hastings Corporation? Assume that Vandell now has $10.82 million in debt.

Building off our previous problem, we need to first of all figure out our unlevered cost of equity as annontated
on page 881. RsU = WsRsL + WdRd

Weight of debt 0.3

Weight of equity 0.7
Interest rate of debt 8%
Tax rate 40%
Rate of equity 13.4%
g 5%

RsU 11.78%

The tax shields for years 1-3 are fairly straightforward. We simply take the interest payment of $1.5 million
and multiply by our tax rate of 40% to get our tax shields

Interest payment $1.5 million

Tax rate 40%
Years 1-3 tax shield $0.6 million

The year 4 tax shield varies so we'll add in that calculation

Interest payment $1.5 million

Tax rate 40%
Year 4 tax shield $0.5888 million

Now that we know all of tax shields, we need to calculate the horizon value on the tax shield. We know this
calculation to be equal to the last year of the tax shield multiplied by the growth, divided by the (RSU - growth)
This calculation is as follows:

Horizon value = last year tax shield * (1+growth)/(RsU - growth)

Last year tax shield $0.6 million

Growth 5%
RsU 11.78%
Horizon Value $ 9.12 million
Now we have all of our inputs and can calculate the value of the tax shields. This is simply inputting
our calculations into the formula shown on page 888 where we divide each year's tax shelter figure by
1 + RSU and then factoring in the square roots for the future years

Value tax shield $7.67 million

Now we need to figure out the unlevered value of the operations. Once we crack that code we can add in the value
to get the full value of the operations. So we already know that the unlevered value of the ops is equal to each years
1+ RSU. Then for the last year we have to add in the unlevered horizon value as shown on page 887. So let's start wi
horizon value.

This is much like the last year's tax shield horizon value in that it equates to the last year's FCF * (1 + growth) / (RSU

Lear year FCF $3.57 million

G 5%
RSU 11.78%
Unlevered horizon value $ 55.29 million

Now we can find our unlevered ops by peforming much the same equation as we did for the value of the tax shield.
equation can once again be found on page 887.

FCF Year 1 $2.50 million

FCF Year 2 $2.90 million
FCF Year 3 $3.40 million
FCF Year 4 $3.57 million
Unlevered Horizon Value $55.29 million

Unlevered value of Vandell $ 44.69 million

As previously stated, our value of operations is equal to the unlevered value of operations plus the value of tax shiel

Unlevered value of operations $ 44.69 million

Value of tax shields $ 7.67 million
Value of operations $ 52.36 million

Now the value to Harrison must take into account the absorption of debt. For this calculation we simply take the val
minus any debt from Vandell.The we divide by the 1 million outstanding shares to get our value to Harrison

Value of Vandell operations $ 52.36 million

Vandell Debt $ 10.82 million
Value to Harrison $ 41.54 million
Outstanding shares 1 million
Per share value to Harrison $ 41.54 per share
by 5%. Synergies
illion in Years
s the unlevered

of equity as annontated

ment of $1.5 million

shield. We know this

ed by the (RSU - growth)
ply inputting
helter figure by

ode we can add in the value of the tax shields

the ops is equal to each years cash flows divided by
on page 887. So let's start with the unlevered

r's FCF * (1 + growth) / (RSU - growth)

or the value of the tax shield. This extensive

ons plus the value of tax shields

lation we simply take the value of operations

ur value to Harrison
CHAPTER 22 HOMEWORK

22-3) On the basis of your answers to Problems 22-1 and 22-2, indicate the range of possible prices that
Hastings could bid for each share of Vandell common stock in an acquisition.

Based on our two answers, the range of prices could be anywhere from $25.26 per share to
$41.54 per share.
ble prices that
CHAPTER 23 HOMEWORK

23-3) What is the implied interest rate on a Treasury bond ($100,000) futures contract that settled at
100'16? If interest rates increased by 1%, what would be the contract's new value?

Once again, our toolkit sets up the problem very well for us. We are assuming that the bonds are
issued at 6% coupon for a period of 20 years with coupon payments paid semi-annually. From
the calculations below we can see that the implied interst rate is 5.96%.

Total Bonds Sold 100

Price in whole units 100
Price in 32nds 16
Maturity in semiannual period 40
Semiannual coupon payments $30
Maturity value $1,000
Price $1,005.00
Total value $100,500.00
Semiannual implied yield 2.98%
Annual implied yield 5.96%

We know from our text if interest rates increase, the value of the debt issuance decreases.

New Interest Rate 6.96%

Maturity in semiannual period 40
Semiannual coupon payments $30
Maturity value $1,000
New Price $897.48
Total Value of New Contract $89,748.42

Thus, we can see that the increase of 1% caused our value to decrease from $100,500 to
$89,748.54.
at settled at

the bonds are

ually. From
CHAPTER 23 HOMEWORK

23-4) Carter Enterprises can issue floating-rate debt at LIBOR + 2% or fixed-rate debt at 10%. Brence
Manufacturing can issue floating-rate debt at LIBOR + 3.1% or fixed-rate debt at 11%. Suppose Carter
makes a fixed-rate payment of 7.95% to Brench and Brence makes a payment of LIBOR to Carter.
What are the net payments of Carter and Brence if they engage in the wap? Would Carter be better
off if it issued fixed-rate debt or if it issued floating-rate debt and engaged in the swap? Would Brence
be better off if it issued floating-rate debt or if it issued fixed-rate debt and engaged in the swap?

Let's take these one at a time to determine if this transaction makes sense for both Carter and Brence.

So let's say Carter issued the floating-rate debt and swaps with Brence. If Carter executes this transaction
the firm will make a payment of 7.95% to Brence and the LIBOR cost will be 2%. This equates to net cash flows
9.95% for Carter which is less than the 10% fixed rate. So this deal benefits Carter.

Now for Brence, we need to see if the fixed-rate debt and swap is better. So in this scenario Brence issues
debt at 11% fixed but receives a payment of 7.95% from Carter. This nets Brence 3.05% which is below the
floating rate debt of LIBOR + 3.1%, so the deal benefits Brence as well.

Both companies should perform the swap! See calculations below:

Carter Brence
Floating rate: LIBOR + 2.00% 3.10%
Fixed rate: 10.00% 11.00%

Carter Brence
Payment to lender: -LIBOR -2.00% -11.00%
Payment to swap counterparty: -7.95% -LIBOR
Payment from swap counterparty: +LIBOR 7.95%

Net payment: -9.95% -LIBOR -3.05%

%. Suppose Carter
OR to Carter.
Carter be better
ap? Would Brence
in the swap?

Carter and Brence.

cutes this transaction

s equates to net cash flows

cenario Brence issues

5% which is below the
CHAPTER 23 HOMEWORK

23-5) The Zinn Company plans to issue $10,000,000 of 20-year bonds in June to help finance a new research
and development laboratory. The bonds will pay interest semiannually. It is now November, and the
current cost of debt to the high-risk biotech company is 11%. However, the firm's financial manager
is concerned that interest rates will climb even higher in coming months. The following data are
available:

FUTURE PRICES: TREASURY BONDS --- $100,000; PTS 32NDS OF 100%

Open High Low Settle Change
Delivery Mon(2) (3) (4) (5) (6) Open Interest
Dec 94'28 95'13 94'22 95'05 0'07 591944
Mar 96'03 96'03 95'13 95'25 0'08 120353
Jun 95'03 95'17 95'03 95'17 0'08 13597

a. Use the given data to create a hedge against rising interest rates.

The CH23 P06 Build a Model.xls spreadsheet that accompanied our text proved to be an outstanding tool
to work this problem. I will caveat by saying that I utilized those imputs to solve this problem and interpret
the data. So to start off with problem (a.) we need to figure out how many contacts need to be sold in this
hedge to cover the $10 million bond issuance in June. As those interest rates rise, the company can repurchase
the futures at costs that are much lower than issuance which is the essence of the hedge. Our inputs are
as follows:

Size of planned debt offering = $10,000,000

Anticipated rate on debt offering = 11%
Maturity of planned debt offering = 20
Number of months until debt offering = 7
Settle price on futures contract (% of par) = 95.53125%
Maturity of bond underlying futures contract = 20
Coupon rate on bond underlying futures contract = 6%
Size of futures contract (dollars) = $100,000

Value of each T-bond futures contract = $ 95,531.25

Number of contracts needed for hedge = 104.68 rounding = 105.00 contracts needed to be sold
Value of contracts in hedge = $10,030,781
Implied semi-annual yield = 3.200%
Implied annual yield = 6.399%

b. Assume that interest rates in generate increase by 200 basis points. How well did your hedge
perform?

This is really a two-part question and involves calculating the gain/loss from bond issuance and then
comparing this with dollar value change in the futures position to see if the total dollar value of the hedge
fund increased (made a profit) or decrease (incurred a loss). A 200 point increase is essentially
a 2% increase to our interest rate. Because the rate increased, the value of the bond issuance
will decrease but the firm should theoretically be able to purchase the futures back at a lower
cost as well. So long as the company is able to make more on the futures than what it loses
on the bond issuance, the hedge fund will make money. First let's see how the increase affects the bonds.
 As shown below, the an increase of 200 basis points means that the interest rate on the bond
issuance is now 13% as opposed to 11%. Using the PV calculations, the bond issuance at the new
rate of 13% places the value of those bonds at $8,585,447. Originally, the value of the bond issuance
was $10 million. Therefore, the change in interest rate affected the value of the bond issuance
and essentially caused a "loss" of $1,414,553 (see calculations below).

Change in interest rate on debt offering (basis points) = 200

New interest rate on debt = 13.0%
Value of issuing at new rate interest = $8,585,447
Original value of bond debt offering = $10,000,000
Gain (loss) issuing debt at the new rate = ($1,414,552.69)

Now for the calculation on the futures contracts. We already know that the company is going to
lose money on the bond issuance, but if it can make up the difference and then some on the futures
then the hedge fund will make money. We know from our calculations above, that the implied
annual yield on the futures was 6.3992%. And we know that a 200 point increase in interest rate
percentage equates to a 2% increase. So adding 2% to our annual yield of 6.3992% gives us the
"new yield" on our futures contract. Once again, we use the PV function to calculate the value
of one futures contract sold at the new rate and we get $76,945.56. Recall from earlier that the total
number of contracts in the hedge were 105. So we multiply the new value by the # of contracts
to get the value of all the futures at the new yield which equates to $8,079,284. Because Zinn
originally sold the contracts for $10,030,781 (see calculations above) and can now buy the futures
back at $8,079,284, we see from our calculations below that Zinn made $1,951,497 off the buy-back.

New yield on futures contract = 8.39923%

New value of each futures contract $76,945.56
Value of all the futures contract at new yield = $8,079,284
Original value of the futures sold = $10,030,781
Gain (loss) in value of the futures position = $1,951,497.48

Only thing left to do is to compare the gains/losses from the futures and debt issuance to see
if our hedge came out in the black (gain) or the red (loss):

Gain (loss) in value of the futures position = $1,951,497.48

Gain (loss) issuing debt at the new rate = ($1,414,552.69)
Total dollar value change of hedge = $536,944.79

We can see from our calculations above that the hedge made $536,945 so we came out on top.

c. What is a perfect hedge? Are any real-world hedges perfect? Explain.

Essentially, a "perfect hedge" is one in which the gains on a futures contract would perfectly
offset the losses on the issuance of a bond (debt) (page 928). As our text illustrates, a "real-world
perfect hedge" exists only in theory due to the fact that in order to construct a perfect hedge,
a company must have a future that is perfectly identical to original issuance. Also as our text
highlights, prices do not always move at the same rate in the spot and futures market.
 tstanding tool
m and interpret
be sold in this
any can repurchase
ur inputs are

ntracts needed to be sold

e of the hedge

cts the bonds.