BUS384 – Corporate Finance Korea University

Joonghyuk Kim

Assignment 1
(Due by Oct. 18, 2023)
Please solve the following questions. Please make sure that you write down the names of all of your
group members. The assignment is due at the beginning of class on the due date. A soft copy (in
PDF, word file) must be uploaded to the course blackboard site by the due date and time. Please show
all the intermediate steps and calculations when solving the problems and state your assumptions (if any).
Please type your answers.

1. Which of the following observations appear to indicate market inefficiency? For each case,
explain whether the inefficiency is weak, semi-strong, or strong and explain why briefly.
(Note: If the market is not weak-form-efficient, it is said to be weak-form-inefficient; if it is
not semi-strong-form efficient, it is semi-strong-form-inefficient; and so on)

a. Managers make superior returns on their purchases of their company’s stock.

b. There is a positive relationship between the return on the market in one quarter and the
change in aggregate corporate profits in the next quarter.
c. There is disputed evidence that stocks which have appreciated unusually in the recent
past continue to do so in the future.
d. Stocks of companies with unexpectedly high earnings appear to offer high returns for
several months after the earnings announcement.
e. The market price of a stock moves or fluctuates.
f. A lawyer works for a firm that advises corporate firms planning to sue other corporations
for antitrust damages. He finds that he can "beat the market" by short-selling the stock of
the firm that will be sued.
g. Firms with unexpectedly high earnings earn abnormally high returns for several months
after the announcement.

2. World Cellfone Co. is considering the purchase of a new telecommunications system for $60
million. This system will boost the firm’s productivity so that its operating earnings (or
EBIT) will increase by $12 million per year over the next 8 years. World Cellfone Co.
corporate tax rate is 35% and its debt and equity costs are 7% and 14%, respectively. The
manufacturer of the telecommunications system is willing to loan the firm $25 million for
the purchase at a subsidized rate of 5% (with World Cellfone Co. putting up the remainder
from its retained earnings account). The loan principal is to be paid off in 5 equal
installments over 5 years with interest being paid every year on the loan outstanding. If the
firm’s required rate of return under all-equity financing is 10%, should it go ahead with the
purchase? (Assume that the depreciation amount from the project will be exactly offset by
the increase in capital expenditure.)

3. The SSR Co., currently all-equity firm, is planning to build a factory. The asset beta,
systematic risk, of this project alone is 15% less than they currently manage. The beta,
currently, is 1.5. The corporate tax rate the firm faces is 34%. The company has a target debt-
to-equity ratio of 3/7. The initial investment cost is $30 million and the expected operating
after-tax cash flows are $10 million per year for five years. The risk-free rate is 3% and the
historical market risk premium of 8% is a reasonable estimate. (Assume that you can use the
CAPM equation to estimate the cost of capital of this project.)

a. What is the all-equity value of this investment?

b. If the company finances it with a five-year non-amortizing loan with 11% interest, should
it accept the project (USE APV approach)?
BUS384 – Corporate Finance Korea University
Joonghyuk Kim

c. If the local government approaches the SSR Co. with an offer to loan the needed amount
in b at 8%, should the company accept this offer?

4. Consider two firms, U and L, both with $50,000 in assets. Firm U is unlevered, and firm L
has $20,000 of debt that pays 8% interest. Firm U has 1,000 shares outstanding, while firm
L has 600 shares outstanding. Mike owns 20% of firm L and believes that leverage works
in his favor. Steve tells Mike that this is an illusion, and that with the possibility of
borrowing on his own account at 8% interest, he can replicate Mike's payout from firm L.

a. Given a level of EBIT (or operating income) of $2,500, show the specific strategy that
Steve can replicate Mike’s payout from his investment in firm L. (Assume 100% of income
will be paid as dividend and no taxes.)

b. After seeing Steve's analysis in (a) above, Mike tells Steve that while his analysis looks
good on paper, Steve will never be able to borrow at 8%, but would have to pay a more
realistic rate of 12%. If Mike is right, what will Steve's payout be?

c. Suppose the tax authorities allow firms to deduct their interest expense from operating
income. Both firm U and firm L are in the 34% tax bracket. Show what happens to the
market value of both firms if the debt held by firm L is permanent. Assume MM with taxes.

5. Suppose ABC Inc. has earnings of 6 millions in 2023. Its cost of capital is 20%. ABC Inc.
never borrowed money from any bank or from the public. Now, the CEO of the company
heard that debt has some tax advantage and he knew that ABC Inc. paid a lot of taxes to the
government each year. So, he is thinking about issuing 5 million debt and using the proceeds
to buy back shares in the market. The before-tax cost of debt is 10%. Help him to make the
decision by answering the following questions. Analyze this by assuming no personal taxes
and a flat corporate tax rate of 35%.

a. What’s the market value of ABC Inc. before issuing debt?

b. What’s the market value of ABC Inc. after issuing debt?
c. After issuing debt, what’s the market value of equity and stock price? What’s the stock
price before issuing debt? (Assume ABC Inc. initially has 325,000 shares outstanding.) Is
there any difference of stock prices before and after debt issuance? Why?
d. What’s the cost of equity for ABC Inc. after issuing debt?
e. What’s the weighted average cost of capital for ABC Inc. if 5 million debt is issued?
f. What would you recommend to him? Issue or not issue debt?

6. The common stock and debt of Northern Sludge are valued at $50 million and $30 million,
respectively. Investors currently require a 16% return on the common stock and an 8%
return on the debt. If Northern Sludge issues an additional $10 million of common stock
and uses this money to retire debt, what happens to the expected return on the stock?
Assume that the change in capital structure does not affect the risk of the debt and that there
are no taxes. If there exists 35% of corporate tax, how does your answer change?

7. Massey-Moss Corporation has a perpetual EBIT of $3 million and a 40% tax rate. Let’s
assume that depreciation expense is zero. It is able to borrow at an interest rate of 14%,
whereas its required rate of return on equity in the absence of borrowing is 18%.
BUS384 – Corporate Finance Korea University
Joonghyuk Kim

a. In the absence of personal taxes, what is the value of the firm when it has no debt?
When it has $4 million in debt?
b. If the marginal personal tax rates on stock and bond income are 25% and 30%,
respectively, determine the value of the firm when it has no debt and when it has $4
million in debt.