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Problems

Problem 14-5
Problem 14-9
Problem 14-20
a.

Total Debt 5,000.00
Interest rate 10.00%

Debt Equity Debt Equity
FCF Payments Dividends Payments Dividends
800.00 0 800 500 300
1,000.00 0 1000 500 500
b.
10.00% 80.00 or 100.00 per year
owning 10.00% of the debt and 10.00% of the equity of XYZ.
50.00 per year 50.00 in either case.
30.00 or 50.00 per year
80.00 or 100.00
c.
10.00% 30.00 or 50.00 per year
500.00 and buying 10.00% of the equity of ABC.
80.00 or 100.00
(50.00) per year (50.00) in either case.
30.00 or 50.00
You would receive dividends of
and pay interest of
for a total cash flow of
provide cash flows of
equity in XYZ would
These cash flows could be replicated by
per year, as you would get from buying XYZ equity.
Problem 14-5
XYZ
provide cash flows of
The debt cash flows would be
The equity cash flows would be
For total cash flows of
borrowing
Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has 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 debt, both companies use all remaining free cash
flows to pay dividends each year.
Suppose you hold 10% of the equity of ABC. What is another portfolio you could hold that would provide the
same cash flows?
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?
equity in ABC would
These cash flows could be replicated by
per year, as you would get from buying ABC equity.
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.
ABC
a.

b.
Initial Stock Price 7.50
100.00
Cash 50.00 Cash 350.00 Short term debt 100.00 Cash 0.00 Short term debt 100.00
Long term debt 100.00 Long term debt 100.00
Preferred stock 100.00 Preferred stock 100.00
Existing Assets 700.00 Common Stock 750.00 Existing Assets 700.00 Common stock 750.00 Existing Assets 700.00 Common stock 400.00
Total Assets 750.00
Total Liabilities
& Equity 750.00 Total Assets 1,050.00
Total Liabilities
& Equity 1,050.00 Total Assets 700.00
Total Liabilities
& Equity 700.00
100.00 100.00 53.33
7.50 7.50 7.50
Liabilities
Shares outstanding (millions)
Value per share
After Share Repurchase Initial
Assets Liabilities
After Funding is Received
Assets Liabilities Assets
Initial Shares Outstanding
Market Value Balance Sheet After Each Stage of Zetatron's Leveraged Recapitalization ($ millions)
Shares outstanding (millions)
Value per share
Shares outstanding (millions)
Value per share
ii. After the new securities are issued but before the share repurchase?
At the conclusion of this transaction, how many shares outstanding will Zetatron have, and what will the value of those shares be?
iii. After the share repurchase?
Problem 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.
What is the market value balance sheet for Zetatron
i. Before this transaction?
a.

b.

c.

d.

Unlevered beta 1.20
Expected return 12.50%
Risk-free rate 5.00%
New debt level 40.00%
New D/E 66.67%
Market risk premium 6.25%
a. New beta 2.00
b. New expected return on equity 17.50%
c. Old EPS 1.50
Forward PE 14.00
Price 21.00
Assumed shares 100.00
Old equity 2,100.00
New debt 840.00
New Earnings 108.00
New equity 1,260.00
New shares 60.00
New EPS 1.80
d. New P/E 11.67 Price/Earnings ratio falls
Problem 14-20
What is Yerbas forward P/E ratio after this transaction? Is this change in the P/E ratio
reasonable? Explain.
Yerba Industries is an all-equity firm whose stock has a beta of 1.2 and an expected return of
12.5%. Suppose it issues new risk-free debt with a 5% yield and repurchases 40% of its stock.
Assume perfect capital markets.
What is the beta of Yerba stock after this transaction?
What is the expected return of Yerba stock after this transaction?
Suppose that prior to this transaction, Yerba expected earnings per share this coming year of
$1.50, with a forward P/E ratio (that is, the share price divided by the expected earnings for
the coming year) of 14.
What is Yerbas expected earnings per share after this transaction? Does this change
benefit shareholders? Explain.