Round your answers to two decimal points, and do not round intermediate calculations.
Problem 1.
You have the following information about two firms, Debt Free, Inc. and Debt Spree, Inc. Both firms have the same prospects for sales and EBIT, and both have the same level of assets, tax rate and borrowing rate.
They differ in their use of debt financing.
| Scenario | Sales | EBIT |
| Bad year | 200 | 12 |
| Normal year | 275 | 38 |
| Good year | 380 | 46 |
| Debt Free | Debt Spree | |
| Total assets | 250 | 250 |
| Tax rate | 35 % | 35 % |
| Debt | 0 | 150 |
| Equity | 250 | 100 |
| Avg. interest rate | 16 % | 16 % |
a) Calculate the interest expense for each firm.
b) Compute the return on assets (ROA) for each firm.
c) Compute the net income for each firm.
d) Compute the return on equity for each firm.
e) Which firm should have the higher CAPM đť›˝ based on the information above, assuming they are both in the same industry and at the same stage in their lifecycle? Explain.
Problem 2.
An analyst with a mutual fund is considering buying a FCS Inc corporate bond. She has collected the balance sheet information and income statement info for FCS, as shown in Table 1 (values in thousands). Using the funds internal rating system, shown in Table 2, she computes a set of ratios to determine the appropriate risk premium for the bond.
| Income Statement | |
| Revenue | $ 18,500 |
| Operating and Admin. Expenses | $ 14,050 |
| Operating Income before D&A | $ 4,450 |
| Depreciation & Amortization | $ 1,675 |
| Interest Expense | $ 942 |
| EBT | $ 1,833 |
| Taxes | $ 641 |
| Net income | $ 1,192 |
| Balance Sheet | |
| Current Assets | $ 4,735 |
| Fixed Assets | $ 43,225 |
| Total Assets | $ 47,960 |
| Current Liabilities | $ 4,500 |
| Long-term Debt | $ 10,000 |
| Total Liabilities | $ 14,500 |
| Shareholder Equity | $ 33,460 |
| Total Liabilities & Shareholder Equity | $ 47,960 |
Table 1.
| Rating Table | ||||
| Bond Rating | Interest Coverage | Leverage | Current Ratio | Risk Premium |
| AA | 5.0 to 6.0 | 0.25 to 0.30 | 1.15 to 1.25 | 0.30% |
| A | 4.0 to 5.0 | 0.30 to 0.40 | 1.00 to 1.15 | 0.50% |
| BBB | 3.0 to 4.0 | 0.40 to 0.50 | 0.90 to 1.10 | 1.00% |
| BB | 2.0 to 3.0 | 0.50 to 0.60 | 0.75 to 0.90 | 1.25% |
Table 2.
In the fund’s internal rating system, the interest coverage is defined as EBITDA divided by interest
expense. The leverage is defined as long-term debt divided by book value of equity. The current ratio is defined as current assets divided by current liabilities.
a) Compute the ratios to determine the appropriate bond rating for the FCS Inc bond.
The market debt ratio (MDR) is defined as the book value of total debt divided by the sum of the book value of total debt and the market value of equity. Assume that 1/3 of the current liabilities on FCS Inc’s balance sheet are short-term debt. Currently, FCS Inc’s MDR is 0.40. The beta of the company’s stock is 1.20. The bond is currently trading at a risk premium of 55 basis points
b)Â Assuming a risk-free rate of 3.0%, a market risk premium of 6.0%, and a tax rate of 25%, find the weighted average cost of capital.
c)Â FCS Inc has reached the stable growth stage. Its capital expenditures are 1.12x depreciation, and the change in net working capital is zero. Find the implied growth rate for the free cash flow to the firm (FCFF).