Chapter 15 Questions V1

8/17/2019 Chapter 15 Questions V1

1/6

Capital Structure without Taxes

15.1 Alpha Corporation and Beta Corporation are identical in every way except their capital structures. AlphaCorporation, an all-equity firm, has 5,000 shares of stoc outstandin!, currently worth "#0 per share. BetaCorporation uses levera!e in its capital structure. $he maret value of Beta%s de&t is "#5,000. $he cost ofthis de&t is 1#' per annum. (ach firm is expected to have earnin!s &efore interest of ")50,000 in perpetuity. *either firm pays taxes. Assume that every investor can &orrow at 1#' per annum.

a. +hat is the value of Alpha Corporationb. +hat is the value of Beta Corporationc. +hat is the maret value of Beta Corporation%s equityd. ow much will it cost to purchase #0' of each firm%s equitye. Assumin! each firm meets its earnin!s estimates, what will &e the dollar return to each position in part

d over the next year f. Construct an investment strate!y in which an investor purchases #0' Alpha%s equity and replicates

&oth the cost and dollar return of purchasin! #0' of Beta%s equity. g. s Alpha%s equity more or less risy than Beta%s equity (xplain.

15.# Acetate, nc., has equity with a maret value of "#0 million and de&t with a maret value of "10 million.$he cost of the de&t is 1/' per annum. $reasury &ills that mature in one year yield ' per annum, and the

expected return on the maret portfolio over the next year is 1'. $he &eta of Acetate%s equity is 0.. $hefirm pays no taxes.

a. +hat is Acetate%s de&t-equity ratiob. +hat is the firm%s wei!hted avera!e cost of capitalc. +hat is the cost of capital for an otherwise-identical all-equity firm

15.) 2evered, nc., and 3nlevered, nc. are identical in every way except their capital structures. (ach companyexpects to earn "4 million &efore interest per year in perpetuity, with each company distri&utin! all itsearnin!s as dividends. 2evered%s perpetual de&t has a maret value of "#5 million and costs ' perannum. 2evered has /.5 million shares outstandin!, currently worth "100 per share. 3nlevered has no de&tand 10 million shares outstandin!, currently worth "0 per share. *either firm pays taxes. s 2evered%sstoc a &etter &uy than 3nlevered%s stoc

15./ $he 6e&len Company and the 7ni!ht Company are identical in every respect except that 6e&len is notlevered. $he maret value of 7ni!ht Company%s 4-percent &onds is "1 million. 8inancial information forthe two firms appears &elow. All earnin!s streams are perpetuities. *either firm pays taxes. Both firmsdistri&ute all earnin!s availa&le to common stoc holders immediately.

Veblen Knight

9ro:ected ;peratin! ncome )00,000" )00,000"

toc )00,000" #/0,000"

?equired ?eturn on (quity @r s 0.1#5 0.1/0

Baret 6alue of >toc #,/00,000" 1,1/,000"

Baret 6alue of =e&t - 1,000,000 6alue of the 8irm #,/00,000" #,1/,000"

+ei!hted Avera!e Cost of Capital @r wacc 0.1#5 0.110

=e&t-(quity ?atio 0 0.5/


2/6

a. An investor who is a&le to &orrow at 4' per annum wishes to purchase 5' of 7ni!ht%s equity. Can heincrease his dollar return &y purchasin! 5' of 6e&len%s equity if he &orrows so that the initial net costof the two options are the same

b. iven the two investment strate!ies in part a, which will investors choose +hen will this processcease

15.5 rimsley, nc., is an all-equity firm with 100,000 shares of common stoc outstandin!, worth "50 pershare. *either the firm nor its shareholders pay any taxes. Consider three stocholders of rimsley, s.annon, s. 8inney, and s. race. All three individuals can &orrow and lend at #0' per annum, thesame rate at which the firm lends and &orrows. $he value of their holdin!s in rimsley and of their personal &orrowin! and lendin! positions are listed &elowD

rimsley%s mana!ement has recently decided to alter the firm%s capital structure so that the de&t-to-equityratio of the firm is 0.#5. n order to do this, rimsley issued "1 million in de&t yieldin! #0' per annumand used the funds to repurchase #0,000 shares. *one of these shares were repurchased from s. annon,s. 8inney, or s. race.

$he three stocholders wish to alter their positions so that their payoffs after the restructurin! equal their payoffs prior to the restructurin!. Assume that rimsley immediately distri&utes all earnin!s availa&le tostocholders at the end of the year and that the restructurin! will have no effect on the firm%s earnin!s &efore taxes. >how the values of each of the investor%s shares in rimsley, as well as their &orrowin!, andlendin! positions after they have ad:usted their portfolios.

15.4 ?ay&urn anufacturin!, nc., is currently an all-equity firm that pays no taxes. $he maret value of thefirm%s equity is "# million. $he cost of this unlevered equity is 1' per annum. ?ay&urn plans to issue"/00,000 in de&t and use the proceeds to repurchase stoc. $he cost of de&t is 10' per annum.

a. After ?ay&urn repurchases the stoc, what will the firm%s wei!hted avera!e cost of capital &eb. After the repurchase, what will the cost of equity &e (xplain.c. 3se your answer to part b to compute ?ay&urn%s wei!hted avera!e cost of capital after the repurchase.

s this answer consistent with part a

15. >trom, nc. is an all-equity firm with #50,000 shares of common stoc outstandin!. (ach share is worth"#0. $he firm pays no taxes. $he appropriate discount rate for the firm%s unlevered equity is 15'. >trom%searnin!s last year were "50,000, and mana!ement expects that the firm%s earnin!s will remain at "50,000 per annum into perpetuity.

>trom is plannin! to &uy a competitor%s &usiness for ")00,000. ;nce acquired, the competitor%s facilitiesare expected to increase >trom%s earnin!s &y "1#0,000 per year. $he competitor is also an all-equity firmwith the same riss as >trom and a required return on its equity of 15'.

a. Construct the maret-value &alance sheet for >trom &efore the announcement of the &uyout is made.b. >uppose >trom decides to issue equity in order to fund the &uyout.

i. Accordin! to the efficient-maret hypothesis, what will >trom%s stoc price &e immediately after the announcement.

ii. Construct >trom%s maret-value &alance sheet immediately after the announcement.iii. ow many shares will >trom need to issue in order to fund the &uyoutiv.Construct >trom%s maret-value &alance sheet after the equity issue &ut &efore the purchase is

finaliEed.v. Construct >trom%s maret-value &alance sheet after the purchase is finaliEed.

6alue of $otal $otal

Crimsley >hares Borrowin! 2endin!

s. annon 10,000" #,000" -"

s. 8inney 50,000 - 4,000

s. Crace #0,000 - -


3/6

vi. +hat is the expected return to >trom%s equity holders after the &uyoutvii. +hat is >trom%s wei!hted avera!e cost of capital after the &uyout

c. >uppose >trom decides to issue 10' de&t in order to fund the &uyout.i. Construct >trom%s maret-value &alance sheet immediately after the announcement.ii. Construct >trom%s maret-value &alance sheet after the de&t issue &ut &efore the purchase is

finaliEed.iii. Construct >trom%s maret value &alance sheet after the purchase is finaliEed.iv. +hat is the expected return to >trom%s equity holders after the &uyoutv. +hat is >trom%s wei!hted avera!e cost of capital after the &uyout

15. $he ulf 9ower Company, an all-equity firm, is plannin! to &uild a new power plant. 8inancial data pertainin! to the company and the new power plant are listed &elow. Assume all earnin!s are paid out asdividends.

Company Data

Annual (xpected (arnin!s @in perpetuityD "# million *um&er of >hares ;utstandin!D 10 million

New Power Plant

nitial ;utlayD "#0 million

Added Annual (xpected (arnin!s @in perpetuityD ") million

$he new power plant has the same ris as existin! assets. $he current required rate of return on the firm%sequity is 10 percent. Assume there are no taxes and no costs of &anruptcy.

a. Construct ulf%s maret value &alance sheet &efore the firm announces that it will &uild the new power plant. +hat is the price per share of ulf%s equity

b. >uppose ulf decides to issue equity to fund the initial outlay for the power plant.i. Construct ulf%s maret-value &alance sheet immediately after the announcement. +hat is the

new price per share of the firm%s equityii. ow many shares will ulf need to issue in order to fund the outlayiii. Construct ulf%s maret-value &alance sheet after the equity issue &ut &efore the outlay is made.iv.Construct ulf%s maret-value &alance sheet after the outlay has &een made.

v. +hat will the value of ulf 9ower &e if common stoc is issued to finance the construction of thenew power plant

c. >uppose ulf decides to issue "#0 million of ' &onds in order to fund the initial outlay for the power plant.i. Construct ulf%s maret-value &alance sheet immediately after the announcement. +hat is the

new price per share of the firm%s equityii. Construct ulf%s maret-value &alance sheet after the de&t issue &ut &efore the outlay is made.iii. Construct ulf%s maret-value &alance sheet after the outlay has &een made.iv. +hat will the value of ulf 9ower &e if de&t is issued to finance the construction of the new

power plantv. Calculate the rate of return required &y equity holders after &oth the de&t issue and the completion

of the new plant.vi. Calculate the firm%s wei!hted avera!e cost of capital after &oth the de&t issue and the completion

of the new plant.

15. n a world with no taxes, no transaction costs, and no costs of financial distress, are the followin!statements true, false, or uncertain (xplain your answers.

a. f a firm issues equity to repurchase some of its de&t, the price per share of the firm%s stoc will rise &ecause the shares are less risy.

b. oderate &orrowin! will not increase the required return on a firm%s equity.


4/6

15.10 2ist the three assumptions that lie &ehind the odi!liani-iller theory in a world without taxes. Are theseassumptions reasona&le in the real world (xplain.

15.11 =i!ital >ound, nc., is an all-equity firm with 1 million shares of common stoc outstandin! at "10 pershare. =i!ital is expected to !enerate "1,500,000 of annual earnin!s in perpetuity. ichael 2efton isinterested in acquirin! a 1' stae in the firm%s equity. e will either &orrow #0', /0', or 40' of the purchase price at an interest rate of 10' per annum. Assume that =i!ital >ound does not pay any taxes andthat the firm immediately distri&utes all of its earnin!s as dividends.

a. ow much will it cost for ichael to purchase 1' of =i!ital%s equity, net of de&t, !iven each financin!choice

b. +hat is the expected return on ichael%s investment !iven each financin! choice

15.1# 2ocomotive Corporation is plannin! to repurchase part of its common stoc &y issuin! corporate de&t. Asa result, the firm%s de&t-to-equity ratio is expected to rise from /0' to 50'. $he firm currently has ".5million worth of de&t outstandin!. $he cost of this de&t is 10' per annum. 2ocomotive expects to earn").5 million per annum in perpetuity. 2ocomotive pays no taxes.

a. +hat is the maret value of 2ocomotive Corporation &efore and after the repurchase announcementb. +hat is the expected return on the firm%s equity @r > &efore the announcement of the stoc repurchase

planc. +hat is the expected return on the equity of an otherwise identical all-equity firm @r 0d. +hat is the expected return on the firm%s equity @r > after the announcement of the stoc repurchase

plan

Capital Structure with Corporate Taxes

15.1) $he maret value of a firm with "500,000 of de&t is "1,00,000. $he pre-tax interest rate on de&t is 10' per annum, and the company is in the )/' tax &racet. $he company expects ")04,000 of earnin!s &eforeinterest and taxes every year in perpetuity.

a. +hat would the value of the firm &e if it were financed entirely with equityb. +hat amount of the firm%s annual earnin!s is availa&le to stocholders

15.1/ An all-equity firm has 15,000 shares of common stoc outstandin!, currently worth "#0 per share. tsequity holders require a #0' return. $he firm decides to issue "1 million of 10' de&t and use the proceedsto repurchase common stoc. Accordin! to odi!liani-iller, what is the maret value of the firm%s equityafter the repurchase Assume a )0' corporate tax rate.

15.15 >trider 9u&lishin! Company, an all-equity firm, expects perpetual earnin!s &efore interest and taxes @(B$of "#.5 million per year. >trider%s after-tax, all-equity discount rate is #0'. $he firm is su&:ect to a )/'corporate tax rate.

a. +hat is the value of >trider 9u&lishin!b. f >trider issues "400,000 of de&t and uses the proceeds to repurchase stoc, what will the value of the

firm &e

c. (xplain any difference in your answers to parts a and b.d. +hat assumptions are you main! when valuin! >trider

15.14 i&son, nc., expects perpetual earnin!s &efore interest and taxes of "1.# million per year. $he firm%s pre-tax cost of de&t is ' per annum, and its annual interest expense is "#00,000. Company analysts estimatethat the unlevered cost of i&son%s equity is 1#'. i&son is su&:ect to a )5' corporate tax rate.

a. +hat is the value of this firmb. f there are no costs of financial distress or &anruptcy, what percenta!e of the firm%s capital structure

would &e financed &y de&t


5/6

c. s the conclusion in part b applica&le to the real world

15.1 reen anufacturin!, nc., plans to announce that it will issue "#,000,000 of perpetual de&t and use the proceeds to repurchase common stoc. $he &onds will have a 4' annual coupon rate. reen is currentlyan all-equity firm worth "10,000,000 with 500,000 shares of common stoc outstandin!. After the sale ofthe &onds, reen will maintain the new capital structure indefinitely. reen currently !enerates annual pre-tax earnin!s of "1,500,000. $his level of earnin!s is expected to remain constant in perpetuity. reen issu&:ect to a corporate tax rate of /0'.

a. +hat is the expected return on reen%s equity &efore the announcement of the de&t issueb. Construct reen%s maret-value &alance sheet &efore the announcement of the de&t issue.

+hat is the price per share of the firm%s equityc. Construct reen%s maret-value &alance sheet immediately after the announcement of the de&t issue.d. +hat is reen%s stoc price per share immediately after the repurchase announcemente. ow many shares will reen repurchase as a result of the de&t issue ow many shares of common

stoc will remain after the repurchase f. Construct the maret-value &alance sheet after the restructurin!. +hat is reen%s stoc price per share

after the restructurin! g. +hat is the required return on reen%s equity after the restructurin!

15.1 $he olland Company expects perpetual earnin!s &efore interest and taxes @(B$ of "/ million per year.$he firm%s after-tax, all-equity discount rate @r 0 is 15'. olland is su&:ect to a corporate tax rate of )5'.$he pre-tax cost of the firm%s de&t capital is 10' per annum, and the firm has "10 million of de&t in itscapital structure.

a. +hat is olland%s valueb. +hat is olland%s cost of equity @r >c. +hat is olland%s wei!hted avera!e cost of capital @r wacc

15.1 +illiamson, nc., has a de&t-to-equity ratio of #.5. $he firm%s wei!hted avera!e cost of capital @r wacc is15', and its pre-tax cost of de&t is 10'. +illiamson is su&:ect to a corporate tax rate of )5'.

a. +hat is +illiamson%s cost of equity capital @r >

b. +hat is +illiamson%s unlevered cost of equity capital @r 0c. +hat would +illiamson%s wei!hted avera!e cost of capital @r wacc &e if the firm%s de&t-to-equity ratio

were 0.5 +hat if it were 1.5

15.#0 eneral $ools @$ expects earnin!s &efore interest and taxes @(B$ of "100,000 every year into perpetuity. $he firm currently has no de&t, &ut it can &orrow at 10' per annum. $%s cost of equity @r 0 is#5', and the firm is su&:ect to a corporate tax rate of /0'.

a. +hat is the value of the firmb. +hat will the value of $ &e if it &orrows "100,000 and uses the proceeds to repurchase equity


6/6

15.#1 >tephenson ?eal (state Company is an all-equity firm with 15 million shares of common stoc outstandin!worth ")#.50 per share. >tephenson is plannin! to purchase a hu!e trac of land in southeastern $exas for"100 million. $he land will su&sequently &e leased to tenant farmers, increasin! >tephenson%s annualexpected pre-tax earnin!s &y "#5 million in perpetuity. $he firm%s unlevered cost of equity capital @r 0 is1#.5'. >tephenson is su&:ect to a corporate tax rate of /0'. $he interest rate on >tephenson%s &onds is' per annum.

a. f >tephenson wishes to maximiEe its total maret value, would you recommend that it issue de&t orequity in order to finance the purchase (xplain.

b. Construct >tephenson%s maret-value &alance sheet &efore it announces the purchase.c. >uppose >tephenson decides to issue equity in order to finance the purchase.

i. +hat is the net present value of the pro:ectii. Construct >tephenson%s maret-value &alance sheet after it announces that the firm will finance the

purchase usin! equity. +hat is the new price per share of the firm%s stoc ow many shares will>tephenson need to issue in order to finance the purchase

iii. Construct >tephenson%s maret-value &alance sheet after the equity issue &ut &efore the purchasehas &een made. ow many shares of common stoc does >tephenson have outstandin! +hat isthe price per share of the firm%s stoc

iv. Construct >tephenson%s maret-value &alance sheet after the purchase has &een made.d. >uppose >tephenson decides to issue de&t in order to finance the purchase.

i. +hat will the maret value of >tephenson &e if the purchase is financed with de&tii. Construct >tephenson%s maret-value &alance sheet after &oth the de&t issue and the land purchase.

+hat is the price per share of the firm%s stoce. +hich method of financin! maximiEes the per share stoc price of >tephenson%s equity

Chapter 15 Questions V1

Documents

Transcript of Chapter 15 Questions V1