Last Updated 20 Apr 2022

# Answer to the Corporate Finance

Category Finance, Investment, Money
Words 2879 (11 pages)
23 views

### Chapter 14

Capital Structure in a Perfect Market 14-1.

Consider a project with free cash flows in one year of \$130,000 or \$180,000, with each outcome being equally likely. The initial investment required for the project is \$100,000, and the project’s cost of capital is 20%. The risk-free interest rate is 10%.

Order custom essay Answer to the Corporate Finance with free plagiarism report

GET ORIGINAL PAPER
• a. What is the NPV of this project?
• b. Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. The equity holders will receive the cash flows of the project in one year. How much money can be raised in this way—that is, what is the initial market value of the unlevered equity?
• c. Suppose the initial \$100,000 is instead raised by borrowing at the risk-free interest rate. What are the cash flows of the levered equity, and what is its initial value according to MM? E ? C (1)? = ? ? 1 (130, 000 + 180, 000) = 155, 000, 2 155, 000 NPV = ? 100, 000 = 129,167 ? 100, 000 = \$29,167 1. 20 155, 000 = 129,167 1. 20
• d. Equity value = PV ( C (1)) = Debt payments = 100, 000, equity receives 20,000 or 70,000. Initial value, by MM, is 129,167 ? 100, 000 = \$29,167 . 14-2. You are an entrepreneur starting a biotechnology firm. If your research is successful, the technology can be sold for \$30 million.

If your research is unsuccessful, it will be worth nothing. To fund your research, you need to raise \$2 million. Investors are willing to provide you with \$2 million in initial capital in exchange for 50% of the unlevered equity in the firm.

• a. What is the total market value of the firm without leverage?
• b. Suppose you borrow \$1 million. According to MM, what fraction of the firm’s equity will you need to sell to raise the additional \$1 million you need?
• c. What is the value of your share of the firm’s equity in cases (a) and (b)?

a. b. c. Total value of equity = 2 ? 2m = \$4m MM says the total value of the firm is still \$4 million. \$1 million of debt implies the total value of equity is \$3 million. Therefore, 33% of the equity must be sold to raise \$1 million. In (a), 50% ? \$4m = \$2m. In (b), 2/3? \$3m = \$2m. Thus, in a perfect market, the choice of capital structure does not affect the value of the entrepreneur.

There is a 20% chance that the assets will be worth only \$20 million. The current risk-free rate is 5%, and the Actor's assets have a cost of capital of 10%.

• a. If Acort is unlevered, what is the current market value of its equity?
• b. Suppose instead that Acort has a debt with a face value of \$20 million due in one year. According to MM, what is the value of the Actor's equity in this case?
• c. What is the expected return of the Actor's equity without leverage? What is the expected return of the Actor's equity with leverage?
• d. What is the lowest possible realized return of Acort’s equity with and without leverage?

a. b. c. d. 14-4. E[Value in one year] = 0. 8 ( 50 ) + 0. 2 ( 20 ) = 44 . E = D= 44 = \$40m. 1. 10 20 = 19. 048 . Therefore, E = 40 ? 19. 048 = \$20. 952m. 1. 05 44 44 ? 20 ? 1 = 10% , with leverage, r = ? 1 = 14. 55%. 40 20. 952 20 0 ? 1 = ? 50% , with leverage, r = ? 1 = ? 100%. 40 20. 952.

Without leverage, r= Without leverage, r= Wolfrum Technology (WT) has no debt. Its assets will be worth \$450 million in one year if the economy is strong, but only \$200 million in one year if the economy is weak. Both events are equally likely. The market value today of its assets is \$250 million.

• a. What is the expected return of WT stock without leverage?
• b. Suppose the risk-free interest rate is 5%. If WT borrows \$100 million today at this rate and uses the proceeds to pay an immediate cash dividend, what will be the market value of its equity just after the dividend is paid, according to MM
• c. What is the expected return of MM stock after the dividend is paid in part (b)?

a. b. c. 14-5. (. 5 ? 450+. 5 ? 200)/250 = 1. 30 => 30% E + D = 250, D = 100 => E = 150 (. 5 ? (450-105) + . 5 ? (200-105))/150 = 1. 4667 => 46. 67% Suppose there are no taxes.

Firm ABC has no debt, and firm XYZ has a debt of \$5000 on which it pays interest of 10% each year. Both companies have identical projects that generate free cash flows of \$800 or \$1000 each year. After paying any interest on the debt, both companies use all remaining free cash flows to pay dividends each year.

• a. Fill in the table below showing the payments debt and equity holders of each firm will receive given each of the two possible levels of free cash flows.
• b. Suppose you hold 10% of the equity of ABC. What is another portfolio you could hold that would provide the same cash flows? 2011 Pearson Education, Inc. Publishing as Prentice Hall 186 Berk/DeMarzo.
• c. Suppose you hold 10% of the equity of XYZ. If you can borrow at 10%, what is an alternative strategy that would provide the same cash flows?

ABC Debt Payments Equity Dividends 0 800 0 1000 XYZ Debt Payments Equity Dividends 500 300 500 500 a. FCF \$800 \$1,000 b. c. 14-6. Unlevered Equity = Debt + Levered Equity. Buy 10% of XYZ debt and 10% of XYZ Equity, get 50 + (30,50) = (80,100) Levered Equity = Unlevered Equity + Borrowing. Borrow \$500, buy 10% of ABC, receive (80,100) – 50 = (30, 50)

Suppose Alpha Industries and Omega Technology have identical assets that generate identical cash flows. Alpha Industries is an all-equity firm, with 10 million shares outstanding that trade for a price of \$22 per share. Omega Technology has 20 million shares outstanding as well as a debt of \$60 million.

• a. According to MM Proposition I, what is the stock price for Omega Technology?
• b. Suppose Omega Technology stock currently trades for \$11 per share. What arbitrage opportunity is available? What assumptions are necessary to exploit this opportunity?

a. b. V(alpha) = 10 ? 22 = 220m = V(omega) = D + E ?

E = 220 – 60 = 160m ? p = \$8 per share. Omega is overpriced. Sell 20 Omega, buy 10 alpha, and borrow 60. Initial = 220 – 220 + 60 = 60. Assumes we can trade shares at current prices and that we can borrow at the same terms as Omega (or own Omega debt and can sell at the same price). 14-7. Croft is a highly profitable technology firm that currently has \$5 billion in cash. The firm has decided to use this cash to repurchase shares from investors, and it has already announced these plans to investors. Currently, Cisoft is an all-equity firm with 5 billion shares outstanding. These shares currently trade for \$12 per share.

Croft has issued no other securities except for stock options given to its employees. The current market value of these options is \$8 billion.

• a. What is the market value of Cisoft’s non-cash assets?
• b. With perfect capital markets, what is the market value of Cisoft’s equity after the share repurchase? What is the value per share?
• c. Assets = cash + non-cash, Liabilities = equity + options, Non-cash assets = equity + options – cash = 12 ? 5 + 8 – 5 = 63 billion. Equity = 60 – 5 =55. Repurchase Per share value = 55 = \$12 . 4. 583 5b = 0. 417b shares ? 4. 583 b shares remain. 12 b. 14-8.

Schwartz Industry is an industrial company with 100 million shares outstanding and a market capitalization (equity value) of \$4 billion. It has \$2 billion of debt outstanding. Management has decided to deliver the firm by issuing new equity to repay all outstanding debt.

• a. How many new shares must the firm issue?
• b. Suppose you are a shareholder holding 100 shares, and you disagree with this decision. Assuming a perfect capital market, describe what you can do to undo the effect of this decision.
• c. Share price = 4b/100m = \$40, Issue 2b/40 = 50 million shares ©2011 Pearson Education, Inc. Publishing as Prentice Hall
• d. You can undo the effect of the decision by borrowing to buy additional shares, in the same proportion as the firm’s actions, thus delivering your own portfolio. In this case, you should buy 50 new shares and borrow \$2000. 14-9. Zetatron is an all-equity firm with 100 million shares outstanding, which are currently trading for \$7. 50 per share. A month ago, Zetatron announced it will change its capital structure by borrowing \$100 million in short-term debt, borrowing \$100 million in long-term debt, and issuing \$100 million of preferred stock.

The \$300 million raised by these issues, plus another \$50 million in cash that Zetatron already has, will be used to repurchase existing shares of stock. The transaction is scheduled to occur today. Assume perfect capital markets.

• a. What is the market value balance sheet for Zetatron
• b. Before this transaction?
• c. After the new securities are issued but before the share repurchase?
• d. After the share repurchase?
• e. At the conclusion of this transaction, how many shares outstanding will Zetatron have, and what will the value of those shares be?
• g. A = 50 cash + 700 non-cash L = 750 equity A = 350 cash + 700 non-cash L = 750 equity + 100 short-term debt + 100 long-term debt + 100 preferred stock iii. A = 700 non-cash L = 400 equity + 100 short-term debt + 100 long-term debt + 100 preferred stock b. 14-10. Repurchase 350 400 = 46. 67 shares? 53. 33 remain. Value is = 7. 50. 7. 50 53. 33 Explain what is wrong with the following argument: “If a firm issues debt that is risk-free, because there is no possibility of default, the risk of the firm’s equity does not change.

Therefore, risk-free debt allows the firm to get the benefit of a low cost of capital of debt without raising its cost of capital of equity. ” Any leverage raises the equity cost of capital. In fact, risk-free leverage raises it the most (because it does not share any of the risks). 14-11. Consider the entrepreneur described in Section 14. 1 (and referenced in Tables 14. 1–14. 3). Suppose she funds the project by borrowing \$750 rather than \$500. a. According to MM Proposition I, what is the value of the equity? What are its cash flows if the economy is strong? What are its cash flows if the economy is weak?

Hardmon Enterprises is currently an all-equity firm with an expected return of 12%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares.

• a. Suppose Hardmon borrows to the point that its debt-equity ratio is 0. 50. With this amount of debt, the debt cost of capital is 6%. What will the expected return of equity be after this transaction?
• b. Suppose instead Hardmon borrows to the point that its debt-equity ratio is 1. 50. With this amount of debt, Hardmon’s debt will be much riskier. As a result, the debt cost of capital will be 8%. What will the expected return of equity be in this case?
• c. A senior manager argues that it is in the best interest of the shareholders to choose the capital structure that leads to the highest expected return for the stock. How would you respond to this argument?

a. b. c. 14-13. re = ru + d/e(ru – rd) = 12% + 0. 50(12% – 6%) = 15% re = 12% + 1. 0(12% – 8%) = 18%. Returns are higher because risk is higher—the return fairly compensates for the risk. There is no free lunch. Suppose Microsoft has no debt and an equity cost of capital of 9. 2%. The average debt-to-value ratio for the software industry is 13%. What would its cost of equity be if it took on the average amount of debt for its industry at a cost of debt of 6%? At a cost of debt of 6%: D (rU ? rD ) E 0. 13 rE = 0. 092 + (0. 092 ? 0. 06) 0. 87 = 0. 0968 rE = rU + = 9. 68%. 14-14. Global Pistons (GP) has common stock with a market value of \$200 million and debt with a value of \$100 million.

Investors expect a 15% return on the stock and a 6% return on the debt. Assume perfect capital markets. a. Suppose GP issues \$100 million of new stock to buy back the debt. What is the expected return of the stock after this transaction? i. If the risk of the debt does not change, what is the expected return of the stock after this transaction? b. Suppose instead GP issues \$50 million of new debt to repurchase stock. ii. If the risk of the debt increases, would the expected return of the stock be higher or lower than in part (i)? ©2011 Pearson Education, Inc. Publishing as Prentice Hall

#### Berk/DeMarzo

Corporate Finance, Second Edition 2 (15% ) 6% + = 12% = ru . 3 3 189 a. b. wacc = i. re = ru + d / e ( ru ? rd ) = 12 + 150 (12 ? 6) = 18% 150. If rd is higher, re is lower. The debt will share some of the risks. 14-15. Hubbard Industries is an all-equity firm whose shares have an expected return of 10%. Hubbard does a leveraged recapitalization, issuing debt and repurchasing stock until its debt-equity ratio is 0. 60. Due to the increased risk, shareholders now expect a return of 13%. Assuming there are no taxes and Hubbard’s debt is risk-free, what is the interest rate on the debt? acc = ru = 10% = 1 0. 6 x ? 1. 6 (10) ? 13 = 3 = 0. 6 x ? x = 5% 13% + 1. 6 1. 6 14-16. Hartford Mining has 50 million shares that are currently trading for \$4 per share and \$200 million worth of debt. The debt is risk-free and has an interest rate of 5%, and the expected return of Hartford stock is 11%. Suppose a mining strike causes the price of Hartford stock to fall 25% to \$3 per share. The value of the risk-free debt is unchanged. Assuming there are no taxes and the risk (unlevered beta) of Hartford’s assets is unchanged, what happens to Hartford’s equity cost of capital? u = WACC = 1 1 200 (11) + (5) = 8% . re = 8% + (8% ? 5%) = 12% 2 2 150 14-17. Mercer Corp. is an all-equity firm with 10 million shares outstanding and \$100 million worth of debt outstanding.

Its current share price is \$75. Mercer’s equity cost of capital is 8. 5%. Mercer has just announced that it will issue \$350 million worth of debt. It will use the proceeds from this debt to pay off its existing debt and use the remaining \$250 million to pay an immediate dividend. Assume perfect capital markets.

• a. Estimate Mercer’s share price just after the recapitalization is announced, but before the transaction occurs.
• b. Estimate Mercer’s share price at the conclusion of the transaction. (Hint: use the market value balance sheet. ).
• c. Suppose Mercer’s existing debt was risk-free with a 4. 25% expected return, and its new debt is risky with a 5% expected return. Estimate Mercer’s equity cost of capital after the transaction.

a. b. MM => no change, \$75 Initial enterprise value = 75 ? 10 + 100 = 850 million New debt = 350 million E = 850 – 350 = 500 Share price = 500/10 = \$50 c. Ru = (750/850) ? 8. 5% + (100/850) ? 4. 25% = 8% Re = 8% + 350/500(8% – 5%) = 10. 1%.

Corporate Finance, Second Edition In June 2009, Apple Computer had no debt, total equity capitalization of \$128 billion, and an (equity) beta of 1. 7 (as reported on Google Finance). Included in Apple’s assets was \$25 billion in cash and risk-free securities. Assume that the risk-free rate of interest is 5% and the market risk premium is 4%.

a. b. 128-25=103 million Because the debt is risk-free? U = E ? E E+D 128 = (1. 7) 103 = 2. 11 c. rWACC = rf + ? ( E[ RMkt ] ? rf ) = 5 + 2. 11? 4 = 13. 4% alternatively rE = rf + ? E ( E[ RMkt ] ? rf ) = 5 + 1. 7 ? 4 = 11. 8% E D \$128 \$25 rE + rD = (11. 8%) ? (5%) = 13. 4% E+D E+D \$103 \$103 rwacc = 14-19.

### Related Questions

on Answer to the Corporate Finance

What is the aim of corporate finance theory?

What is the aim of corporate finance theory? Historically, the most widely accepted goal of financial management has been to: a. analyze the risk associated with investments. b. organize and manage a firm's resources. c. help a firm fulfill i How is the concept of project finance implemented in the context of the Corporate Banking?

What are the core principles of corporate finance?

Explain the core principles of corporate finance. In particular, what is the goal of corporate finance, and what are the major decisions ? The primary goal of financial management is to: a. maximize current dividends per share of the existing stock. b. avoid financial distress. c. minimize operational costs and maximize firm effici

What are the three areas of concern of corporate finance?

Identifying problems that could develop if the firm's strategic plans do not develop as expected. b. Evaluating the firm's Corporate finance has three main areas of concern: a. Capital Budgeting: What long-term investments should the firm take? b. Capital structure: Where will the firm get the long-term financing to pa

What is the goal of the study of modern corporate finance?

One of the goals of the study of modern corporate finance is to maximize agency costs. Five years ago, NorthWest Water (NWW) issued \$50,000,000 face value of 30-year bonds carrying a 14% (annual payment) coupon. NWW is now considering refunding these bonds. It has been amortizing \$3

This essay was written by a fellow student. You can use it as an example when writing your own essay or use it as a source, but you need cite it.

## Get professional help and free up your time for more important courses

Starting from 3 hours delivery 450+ experts on 30 subjects
get essay help 124  experts online

Did you know that we have over 70,000 essays on 3,000 topics in our database?