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Penn State - RUS 100 - Study Guide

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Penn State - RUS 100 - Study Guide

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background image Capital Structure without Taxes 15.1 Alpha Corporation and Beta Corporation are identical in every way except their capital structures.  Alpha 
Corporation, an all-equity firm, has 5,000 shares of stock outstanding, currently worth $20 per share.  Beta 
Corporation uses leverage in its capital structure.  The market value of Beta’s debt is $25,000.  The cost of 
this debt is 12% per annum.  Each firm is expected to have earnings before interest of $350,000 in 
perpetuity. Neither firm pays taxes.  Assume that every investor can borrow at 12% per annum.
a. What is the value of Alpha Corporation?
b. What is the value of Beta Corporation?
What is the market value of Beta Corporation’s equity? d. How much will it cost to purchase 20% of each firm’s equity?
Assuming each firm meets its earnings estimates, what will be the dollar return to each position in part 
d over the next year?
f. Construct an investment strategy in which an investor purchases 20% Alpha’s equity and replicates 
both the cost and dollar return of purchasing 20% of Beta’s equity.
g. Is Alpha’s equity more or less risky than Beta’s equity? Explain. 15.2 Acetate, Inc., has equity with a market value of $20 million and debt with a market value of $10 million.  
The cost of the debt is 14% per annum.  Treasury bills that mature in one year yield 8% per annum, and the 
expected return on the market portfolio over the next year is 18%.  The beta of Acetate’s equity is 0.9.  The 
firm pays no taxes.
a. What is Acetate’s debt-equity ratio?
b. What is the firm’s weighted average cost of capital?
What is the cost of capital for an otherwise-identical all-equity firm? 15.3 Levered, Inc., and Unlevered, Inc. are identical in every way except their capital structures.  Each company 
expects to earn $96 million before interest per year in perpetuity, with each company distributing all its 
earnings as dividends. Levered’s perpetual debt has a market value of $275 million and costs 8% per 
annum.  Levered has 4.5 million shares outstanding, currently worth $100 per share.  Unlevered has no debt
and 10 million shares outstanding, currently worth $80 per share. Neither firm pays taxes.  Is Levered’s 
stock a better buy than Unlevered’s stock?
15.4 The Veblen Company and the Knight Company are identical in every respect except that Veblen is not 
levered.  The market value of Knight Company’s 6-percent bonds is $1 million. Financial information for 
the two firms appears below. All earnings streams are perpetuities.  Neither firm pays taxes.  Both firms 
distribute all earnings available to common stock holders immediately.
Veblen Knight Projected Operating Income 300,000 $        300,000 $        Year-End Interest on Debt -                      60,000            Projected Earnings Available to Common Stock 300,000 $        240,000 $        Required Return on Equity (r s ) 0.125              0.140              Market Value of Stock 2,400,000 $     1,714,000 $     Market Value of Debt -                      1,000,000        Value of the Firm 2,400,000 $     2,714,000 $     Weighted Average Cost of Capital (r wacc ) 0.125              0.110              Debt-Equity Ratio 0 0.584             
background image a. An investor who is able to borrow at 6% per annum wishes to purchase 5% of Knight’s equity.  Can he  increase his dollar return by purchasing 5% of Veblen’s equity if he borrows so that the initial net cost 
of the two options are the same?
b. Given the two investment strategies in part a, which will investors choose? When will this process  cease? 15.5 Grimsley, Inc., is an all-equity firm with 100,000 shares of common stock outstanding, worth $50 per 
share.  Neither the firm nor its shareholders pay any taxes.  Consider three stockholders of Grimsley, Ms. 
Hannon, Ms. Finney, and Ms. Grace.  All three individuals can borrow and lend at 20% per annum, the 
same rate at which the firm lends and borrows.  The value of their holdings in Grimsley and of their 
personal borrowing and lending positions are listed below:
Grimsley’s management has recently decided to alter the firm’s capital structure so that the debt-to-equity 
ratio of the firm is 0.25.  In order to do this, Grimsley issued $1 million in debt yielding 20% per annum 
and used the funds to repurchase 20,000 shares.  None of these shares were repurchased from Ms. Hannon, 
Ms. Finney, or Ms. Grace. 
The three stockholders wish to alter their positions so that their payoffs after the restructuring equal their 
payoffs prior to the restructuring.  Assume that Grimsley immediately distributes all earnings available to 
stockholders at the end of the year and that the restructuring will have no effect on the firm’s earnings 
before taxes. Show the values of each of the investor’s shares in Grimsley, as well as their borrowing, and 
lending positions after they have adjusted their portfolios.  
15.6 Rayburn Manufacturing, Inc., is currently an all-equity firm that pays no taxes. The market value of the 
firm’s equity is $2 million.  The cost of this unlevered equity is 18% per annum. Rayburn plans to issue 
$400,000 in debt and use the proceeds to repurchase stock. The cost of debt is 10% per annum.
a. After Rayburn repurchases the stock, what will the firm’s weighted average cost of capital be?
b. After the repurchase, what will the cost of equity be? Explain.
Use your answer to part b to compute Rayburn’s weighted average cost of capital after the repurchase. 
Is this answer consistent with part a?
15.7 Strom, Inc. is an all-equity firm with 250,000 shares of common stock outstanding.  Each share is worth 
$20. The firm pays no taxes.  The appropriate discount rate for the firm’s unlevered equity is 15%. Strom’s 
earnings last year were $750,000, and management expects that the firm’s earnings will remain at $750,000
per annum into perpetuity.
Strom is planning to buy a competitor’s business for $300,000.  Once acquired, the competitor’s facilities 
are expected to increase Strom’s earnings by $120,000 per year. The competitor is also an all-equity firm 
with the same risks as Strom and a required return on its equity of 15%.
a. Construct the market-value balance sheet for Strom before the announcement of the buyout is made.
b. Suppose Strom decides to issue equity in order to fund the buyout.
i. According to the efficient-market hypothesis, what will Strom’s stock price be immediately after
the announcement.
ii. Construct Strom’s market-value balance sheet immediately after the announcement.
iii. How many shares will Strom need to issue in order to fund the buyout?
iv.Construct Strom’s market-value balance sheet after the equity issue but before the purchase is 
finalized. v. Construct Strom’s market-value balance sheet after the purchase is finalized. Value of  Total Total Grimsley Shares Borrowing Lending Ms. Hannon 10,000 $                  2,000 $       - $               Ms. Finney 50,000                     -                 6,000          Ms. Grace 20,000                     -                 -                

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School: Pennsylvania State University
Department: Russian
Course: Corporate Finance
Term: Spring 2014
Description: Capital Structure without Taxes 15
Uploaded: 07/08/2017
6 Pages 78 Views 62 Unlocks
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