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Problem Set 3

The document contains 9 problems related to corporate finance and capital structure. Problem 1 asks about maintaining proportional ownership through a stock issue used to repay debt. Problem 2 calculates new cost of equity, WACC, PE ratio, stock price and beta after debt repayment through share repurchase. Problem 3 considers the effect on expected equity return of issuing new shares to repay debt. Problems 4-8 consider Modigliani-Miller propositions and leverage effects. Problem 9 recalculates variables with new debt ratio and interest rate.

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Omar Srour
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130 views

Problem Set 3

The document contains 9 problems related to corporate finance and capital structure. Problem 1 asks about maintaining proportional ownership through a stock issue used to repay debt. Problem 2 calculates new cost of equity, WACC, PE ratio, stock price and beta after debt repayment through share repurchase. Problem 3 considers the effect on expected equity return of issuing new shares to repay debt. Problems 4-8 consider Modigliani-Miller propositions and leverage effects. Problem 9 recalculates variables with new debt ratio and interest rate.

Uploaded by

Omar Srour
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Problem Set 3

1. Homemade leverage Ms. Kraft owns 50,000 shares of the common stock of Copperhead
Corporation with a market value of $2 per share, or $100,000 overall. The company is currently
financed as follows:

Copperhead now announces that it is replacing $1 million of short-term debt with an issue of common
stock. What action can Ms. Kraft take to ensure that she is entitled to exactly the same proportion of
profits as before?

2. Leverage and the cost of capital Spam Corp. is financed entirely by common stock and has a beta
of 1.0. The firm is expected to generate a level, perpetual stream of earnings and dividends. The stock
has a price–earnings ratio of 8 and a cost of equity of 12.5%. The company's stock is selling for $50.
Now the firm decides to repurchase half of its shares and substitute an equal value of debt. The debt
is risk-free, with a 5% interest rate. The company is exempt from corporate income taxes. Assuming
MM are correct, calculate the following items after the refinancing:
a. The cost of equity
b. The overall cost of capital (WACC)
c. The price–earnings ratio
d. The stock price
e. The stock's beta

3. Leverage and the cost of capital The common stock and debt of Northern Sludge are valued at
$50 million and $30 million, respectively. Investors currently require a 16% return on the common
stock and an 8% return on the debt. If Northern Sludge issues an additional $10 million of common
stock and uses this money to retire debt, what happens to the expected return on the stock? Assume
that the change in capital structure does not affect the risk of the debt and that there are no taxes.

4. MM's propositions True or false?


a. MM's propositions assume perfect financial markets, with no distorting taxes or other
imperfections.
b. MM's proposition 1 says that corporate borrowing increases earnings per share but reduces the
price–earnings ratio.
c. MM's proposition 2 says that the cost of equity increases with borrowing and that the increase is
proportional to D/V, the ratio of debt to firm value.
d. MM's proposition 2 assumes that increased borrowing does not affect the interest rate on the firm's
debt.
e. Borrowing does not increase financial risk and the cost of equity if there is no risk of bankruptcy.
f. Borrowing always increases firm value if there is a clientele of investors with a reason to prefer debt.

5. Leverage and the cost of capital Gaucho Services starts life with all-equity financing and a cost of
equity of 14%. Suppose it refinances to the following market-value capital structure:
Use MM's proposition 2 to calculate the new cost of equity. Gaucho pays taxes at a marginal rate
of Tc = 40%. Calculate Gaucho's after-tax weighted-average cost of capital.

6. Homemade leverage Companies A and B differ only in their capital structure. A is financed 30%
debt and 70% equity; B is financed 10% debt and 90% equity. The debt of both companies is risk-free.
a. Rosencrantz owns 1% of the common stock of A. What other investment package would produce
identical cash flows for Rosencrantz?
b. Guildenstern owns 2% of the common stock of B. What other investment package would produce
identical cash flows for Guildenstern?
c. Show that neither Rosencrantz nor Guildenstern would invest in the common stock of B if
the total value of company A were less than that of B.

7. MM proposition 1 Executive Chalk is financed solely by common stock and has outstanding 25
million shares with a market price of $10 a share. It now announces that it intends to issue $160 million
of debt and to use the proceeds to buy back common stock.
a. How is the market price of the stock affected by the announcement?
b. How many shares can the company buy back with the $160 million of new debt that it issues?
c. What is the market value of the firm (equity plus debt) after the change in capital structure?
d. What is the debt ratio after the change in structure?
e. Who (if anyone) gains or loses?

8. Leverage and the cost of capital Archimedes Levers is financed by a mixture of debt and equity.
You have the following information about its cost of capital:

Can you fill in the blanks?

9. Leverage and the cost of capital Look back at Problem 8. Suppose now that Archimedes
repurchases debt and issues equity so that D/V = .3. The reduced borrowing causes 𝑟𝐷 to fall to 11%.
How do the other variables change?

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