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Manal Elkhoshkhany, Tutor

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TO BUSINESS TUTOR:QUESTION 1:You work for a major

Customer Question

TO BUSINESS TUTOR: QUESTION 1: You work for a major consultancy firms in corporate finance. Your firm has been approached by one of its major clients to assist them in solving a problem that they have. You have been assigned the task to solve the client’s problem. A shareholder of a firm is wondering what to do in the following situation. The firm is considering an investment that will have one of three EBIT next year: $2,000,000; $3,000,000 or $4,000,000. The issue that the shareholder wants your help with is concerning how to finance the investment. The firm has two possible ways of financing the investment; either by issuing new shares or by a combination of issuing shares and issuing bonds. If fully equity funded the firm will issue 200,000 shares and sell them at $100 a share. If the firm chooses to use debt as part of the financing it will only issue 100,000 shares at $100 and raise $10,000,000 by selling bonds at a yield of 12%. You are asked to do the following by the shareholder using a spreadsheet program: • Analyze the two capital structures for the three different EBIT-scenarios for the shareholder by calculating the EPS for the six possible outcomes. • Use the above to create a graph showing EBIT on the x-axis and EPS on the y-axis for the two capital structure alternatives so the shareholder can see how they relate to each other. • Solve for the break-even EBIT so the shareholder knows above what EBIT leverage is preferable. N.B. Since the client wants to be able to use this spreadsheet in the future for other projects as well you need to use cell references in the formulas. QUESTION 2: You have also been approached by a friend who is evaluating an investment problem. Knowing that you have studied finance, you are asked to help him answering the below questions. Assume the following expected data on two assets: Return State Probability state Bond Stock Recession 30% 15% -10% Normal 40% 10% 0% Boom 30% 5% 20% The stated probabilities shall be changeable as well as the returns in the different states. Build a spreadsheet model to answer the following question: • What is the expected return of the assets? • What is the risk (variance and volatility) for the assets? • What is the correlation between the two asset’s returns? • Assume a portfolio of the two assets. What is the expected return on this portfolio (the user shall be able to change the percentage weight of the assets in the portfolio)? Use a 50%/50% weights to answer this question. • What is the variance and volatility for this 50%/50%-portfolio? • What is the efficient frontier for the two assets given the information in the table above? (Create a suitable graph depicting this.) • What is the minimum variance portfolio and what is the return of this portfolio, i.e. what fraction of the stock and the bond is it made up of? Use the information in the table above for this question. Hint: Use the solver in excel (include solver results) if you cannot solve this algebraically. N.B. Since the client wants to be able to use this spreadsheet in the future for other projects as well you need to use cell references in the formulas

Sorry I did not get back to you earlier, but Please double check Case 1, the tax rate is not provided and that is a very important factor in the analysis. Please check with the instructor and advise me of his response

Am wondering if you could let me know about the formula where the tax rate is required. I may then be able to compare it with the textbook's method and explain this to the instructor as well :).

You do not need the formulaCustomer and the instructor does not need you to explain why do you need the tax rate, but in any case, in case 1 you need to calculate the EBIT indifference level, here is the formula:

I did check it. You are right. I will try and get the tax rate from the instructor tomorrow. I think they might have forgotten to include it in the question.

It wasn't me alone that was wondering about the tax rate issue. Other students had the same issue.

Well, the instructor responded that he deliberately left out the tax rate to simplify the analysis. That is to say, 'we should imagine a world without taxes.' This means that we should not take the tax rate in consideration when doing the analysis.

I agree it sounds weird. What we can do is use the formula you wrote and then in place of 'tax rate' we put zero. so the (1-tax rate) in the formula will replaced by ( 1-0) and

then continue from there. This will make him realize that we used zero tax rate as he suggested.

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I am accepting the answer in few minutes time. I hope I'll be able to get back to you if there is something that I need a further explanation on the answers.

I noticed a slight error in the graph of case one. I see that in calculating the EPS for plan 2, you found the EPS for when EBIT is $4000 000 to be 28 and also EPS to be 28 fro EBIT 5000 000) . When I worked it out the EPS should be 38 when EBIT is 5000 000) could you please confirm this urgently? I chaged it in the graph and I had a straight line graph. Please confirm.

Regards

Customer:replied 5 years ago.

Hi, Please check this chat you sent, I think there is either a slight error or a typing error.

EBIT

EPS Under Plan 1

EPS Under Plan 2

$1 000 000

$5

($2)

$2 000 000

$10

$8

$3 000 000

$15

$18

$4 000 000

$20

$28

$5 000 000

$25

$28not 38 instead?

$6 000 000

$30

$48

the EPS should be 38, when EBIT is $5 000 000

EPS = (5000000- 1 200 000) / 100 000 = 38 and not 28 as written.

Am I correct?

I will appreciate it if you could confirm this right now.