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Wolfrum Technology (WT) has no debt. Its assets will be worth $464 million one year from now if the
economy is strong, but only $229 million in one year if the economy is weak. Both events are equally
likely. The market value today of its assets is $276 million.
b. Suppose the risk-free interest rate is 5 %. If WT borrows $53 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 WT stock after the dividend is paid in part (b)?
3
Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $ 6 comma 000 on which it
pays interest of 10 % each year. Both companies have identical projects that generate free cash flows of
$ 6 comma 400 or $ 6 comma 500 each year. After paying any interest on debt, both companies use all
remaining free cash flows to pay dividends each year.
a. In the table below, fill in the debt payments for each firm and the dividend payments the 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?
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?
a. In the table below, fill in the debt payments for each firm and the dividend payments the equity
holders of each firm will receive given each of the two possible levels of free cash flows. (Round all
answers to the nearest dollar.)
$ 70.00 plus left parenthesis $ 645.00 comma $ 690.00 right parenthesis equals left parenthesis $ 715.00
comma $ 760.00 right parenthesis$70.00+($645.00, $690.00)=($715.00, $760.00)
c. You want the cash flows of the levered firm to equal the cash flows of the unlevered firm. To calculate,
use the following formula:
Levered equity equals Unlevered equity plus BorrowingLevered equity=Unlevered equity+Borrowing
Therefore, an equivalent portfolio to owning
10 %10%
of XYZ equity is to borrow an amount equal to
10 %10%
of the levered firm's (XYZ) debt,
$690.00690.00
for an interest payment of:
Amount Borrowed times Interest rate equals $ 700 times 10 % equals $
70.00Amount Borrowed×Interest rate=$700×10%=$70.00
and buy
10 %10%
of the unlevered firm's equity (ABC), and receive:
left parenthesis $ 715.00 comma $ 760.00 right parenthesis minus $ 70.00 equals left parenthesis $
645.00 comma $ 690.00 right parenthesis($715.00, $760.00)−$70.00=($645.00, $690.00)
Question is complete.
4
Schwartz Industry is an industrial company with 94.8 million shares outstanding and a market
capitalization (equity value) of $ 3.69 billion. It has $1.45 billion of debt outstanding. Management have
decided to delever the firm by issuing new equity to repay all outstanding debt.
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.
5
Hardmon Enterprises is currently an all-equity firm with an expected return of
17 %17%.
It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares.
Assume perfect capital markets.
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
4 %4%.
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
6 %6%.
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. 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
4 %4%.
What will the expected return of equity be after this transaction?
Global Pistons (GP) has common stock with a market value of $ 380$380 million and debt with a value of
$ 290$290 million. Investors expect a 17 %17% return on the stock and a 5 %5% return on the debt.
Assume perfect capital markets.
a. Suppose GP issues
$ 290$290
million of new stock to buy back the debt. What is the expected return of the stock after this transaction?
b. Suppose instead GP issues
$ 58.58$58.58
million of new debt to repurchase stock.
i. If the risk of the debt does not change, what is the expected return of the stock after this transaction?
ii. If the risk of the debt increases, would the expected return of the stock be higher or lower than when
debt is issued to repurchase stock in part
(i)?
a. Suppose GP issues
$ 290$290
million of new stock to buy back the debt. What is the expected return of the stock after this transaction?
In mid-2015, Qualcomm Inc. had $1515 billion in debt, total equity capitalization of $8787 billion, and an
equity beta of 1.491.49 (as reported on Yahoo! Finance). Included inQualcomm's assets was $2424
billion in cash and risk-free securities. Assume that the risk-free rate of interest is 3.1 %3.1%
and the market risk premium is 4.1 %4.1%.
a. What is Qualcomm's enterprise value?
b. What is the beta of Qualcomm's business assets?
c. What is Qualcomm's WACC?
a. What is Qualcomm's enterprise value?
Schwartz Industry is an industrial company with 87.1 million shares outstanding and a market
capitalization (equity value) of $ 4.79 billion. It has $1.26 billion of debt outstanding. Management have
decided to delever the firm by issuing new equity to repay all outstanding debt.
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.
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.
You are an entrepreneur starting a biotechnology firm. If your research is successful, the technology can
be sold for $ 22 million. If your research is unsuccessful, it will be worth nothing. To fund your research,
you need to raise $3.4 million. Investors are willing to provide you with $3.4 million in initial capital in
exchange for 50 % of the unlevered equity in the firm.
b. Suppose you borrow $0.7 million. According to MM, what fraction of the firm's equity will you need to
sell to raise the additional $2.7 million you need?
c. What is the value of your share of the firm's equity in cases (a) and (b)?
b. Suppose you borrow $0.7 million. According to MM, what fraction of the firm's equity will you need to
sell to raise the additional $2.7 million you need?
c. What is the value of your share of the firm's equity in cases (a) and (b)?
In mid-2015, Qualcomm Inc. had $12 billion in debt, total equity capitalization of $91 billion, and an
equity beta of 1.35 (as reported on Yahoo! Finance). Included in Qualcomm's assets was $22 billion in
cash and risk-free securities. Assume that the risk-free rate of interest is 3.1 % and the market risk
premium is 4.1 %.
The WACC is
nothing%. (Round to one decimal place.)
Zelnor, Inc., is an all-equity firm with 180 million shares outstanding currently trading for $ 12.67 per
share. Suppose Zelnor decides to grant a total of 18 million new shares to employees as part of a new
compensation plan. The firm argues that this new compensation plan will motivate employees and is
better than giving salary bonuses because it will not cost the firm anything. Assume perfect capital
markets.
a. If the new compensation plan has no effect on the value of Zelnor's assets, what will be the share
price of the stock once this plan is implemented?
b. What is the cost of this plan for Zelnor investors? Why is issuing equity costly in this case?
a. If the new compensation plan has no effect on the value of Zelnor's assets, what will be the share
price of the stock once this plan is implemented?
If the new compensation plan has no effect on the value of Zelnor's assets, the new share price will be $
b. What is the cost of this plan for Zelnor investors? Why is issuing equity costly in this case?
Why is issuing equity costly in this case? (Select the best choice below.)
A.
It's costly because the shareholder equity is being given away to employees for free.
B.
It is not costly because we are not taking into account the benefit of the equity to the employees. Once
that is accounted for, the value of the firm will be the same.
C.
This is a standard example of the effect of dilution on the share price which is always costly.
D.
a. Suppose GP issues $ 273 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?
ii. If the risk of the debt increases, would the expected return of the stock be higher or lower than when
debt is issued to repurchase stock in part (i)?
a. Suppose GP issues $ 273 million of new stock to buy back the debt. What is the expected return of the
stock after this transaction?
If GP issues $ 273 million of new stock to buy back the debt, the expected return is
i. If the risk of the debt does not change, what is the expected return of the stock after this transaction?
If GP issues $ 96.92 million of new debt to repurchase stock and the risk of the debt does not change,
the expected return is
ii. If the risk of the debt increases, would the expected return of the stock be higher or lower than when
debt is issued to repurchase stock in part (i)? (Select the best choice below.)
Higher
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 5 %. 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 7 %. 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. 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 5 %. What will the expected return of equity be after this transaction?
If Hardmon borrows to the point that its debt-equity ratio is 0.50 and the debt cost of capital is 5 %, the
expected return is
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 7 %. What will the
expected return of equity be in this case?
If Hardmon borrows to the point that its debt-equity ratio is 1.50 and the debt cost of capital is 7 %, the
expected return is
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?
Yerba Industries is an all-equity firm whose stock has a beta of 0.50 and an expected return of 13 %.
Suppose it issues new risk-free debt with a 5.5 % yield and repurchase 30 % of its stock. Assume perfect
capital markets.
Suppose that prior to this transaction, Yerba expected earnings per share this coming year of $ 4.50, with
a forward P/E ratio (that is, the share price divided by the expected earnings for the coming year) of 9.
c. What is Yerba's expected earnings per share after this transaction? Does this change benefit the
shareholder? Explain.
d. What is Yerba's forward P/E ratio after this transaction? Is this change in the P/E ratio reasonable?
Explain.
c. What is Yerba's expected earnings per share after this transaction? Does this change benefit the
shareholder? Explain.
If prior to the transaction, Yerba expected earnings per share this coming year of $ 4.50, with a forward
P/E ratio of 9, Yerba's expected earnings per share after thi
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."
A.
The argument is wrong because any leverage raises the equity cost of capital. Risk-free leverage raises it
the most because it does not share any of the risk.
B.
The argument is wrong because any leverage raises the equity cost of capital. Risk-free leverage raises it
the least because it does not share any of the risk.
C.
The argument is correct because debt has a lower cost of capital than equity and a firm can reduce its
overall weighted average cost of capital by increasing the amount of debt financing.
D.