Capital Structure in a Perfect Market

14.1 Equity Versus Debt Financing

Use the following information to answer the question(s) below.

Nielson Motors (NM) has no debt. Its assets will be worth $600 million in one year if the
economy is strong, but only $300 million if the economy is weak. Both events are equally
likely. The market value today of Nielson's assets is $400 million.

1) The expected return for Nielson Motors stock without leverage is closest to:
A) -25.0%.
B) -17.5%.
C) -12.5%.
D) 12.5%.

2) Suppose the risk-free interest rate is 4%. If Nielson borrows $150 million today at this
rate and uses the proceeds to pay an immediate cash dividend, then according to MM, the
market value of its equity just after the dividend is paid would be closest to:
A) $0 million.
B) $150 million.
C) $250 million.
D) $400 million.

3) Suppose the risk-free interest rate is 4%. If Nielson borrows $150 million today at this
rate and uses the proceeds to pay an immediate cash dividend, then according to MM, the
expected return of Nielson's stock just after the dividend is paid would be closest to:
A) -17.5%.
B) -12.5%.
C) 12.5%.
D) 17.5%.

4) Which of the following statements is FALSE?

A) The relative proportions of debt, equity, and other securities that a firm has outstanding
constitute its capital structure.
B) The most common choices for financing a new project are financing through equity
alone and financing through a combination of debt and equity.
C) The NPV created by a project represents the value to the new investors of the firm.
D) When corporations raise funds from outside investors, they must choose which type of
security to issue.

5) Equity in a firm with debt is called:

A) levered equity.
B) riskless equity.
C) unlevered equity.
D) risky equity.

6) Equity in a firm with no debt is called:

A) levered equity.
B) unlevered equity.
C) riskless equity.
D) risky equity.

7) Which of the following statements is FALSE?

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A) Modigliani and Miller's conclusion verified the common view, which stated that even
with perfect capital markets, leverage would affect a firm's value.
B) We can evaluate the relationship between risk and return more formally by computing
the sensitivity of each security's return to the systematic risk of the economy.
C) Investors in levered equity require a higher expected return to compensate for its
increased risk.
D) Leverage increases the risk of equity even when there is no risk that the firm will
default.

8) Which of the following statements is FALSE?

A) Leverage decreases the risk of the equity of a firm.
B) Because the cash flows of the debt and equity sum to the cash flows of the project, by
the Law of One Price the combined values of debt and equity must be equal to the cash
flows of the project.
C) Franco Modigliani and Merton Miller argued that with perfect capital markets, the total
value of a firm should not depend on its capital structure.
D) It is inappropriate to discount the cash flows of levered equity at the same discount rate
that we use for unlevered equity.

Use the information for the question(s) below.

Consider a project with free cash flows in one year of $90,000 in a weak economy or
$117,000 in a strong economy, with each outcome being equally likely. The initial
investment required for the project is $80,000, and the project's cost of capital is 15%. The
risk-free interest rate is 5%.

9) The NPV for this project is closest to:

A) $6250.
B) $14,100.
C) $10,000.
D) $18,600.

10) 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. The market value of the unlevered equity for this project is closest to:
A) $94,100.
B) $90,000.
C) $86,250.
D) $98,600.

11) Suppose that to raise the funds for the initial investment the firm borrows $80,000 at
the risk-free rate, then the cash flow that equity holders will receive in one year in a weak
economy is closest to:
A) $6000.
B) $10,000.
C) $0.
D) $33,000.

12) Suppose that to raise the funds for the initial investment the firm borrows $80,000 at
the risk-free rate, then the cash flow that equity holders will receive in one year in a strong
economy is closest to:
A) $0.
B) $6000.

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C) $33,000.
D) $10,000.

13) Suppose that to raise the funds for the initial investment the firm borrows $80,000 at
the risk-free rate, then the value of the firm's levered equity from the project is closest to:
A) $0.
B) $10,000.
C) $6000.
D) $8600.

14) Suppose that to raise the funds for the initial investment the firm borrows $80,000 at
the risk-free rate, then the cost of capital for the firm's levered equity is closest to:
A) 45%.
B) 25%.
C) 15%.
D) 95%.

15) Suppose that to raise the funds for the initial investment the firm borrows $40,000 at
the risk-free rate and issues new equity to cover the remainder. In this situation, the cash
flow that equity holders will receive in one year in a weak economy is closest to:
A) $90,000.
B) $0.
C) $50,000.
D) $48,000.

16) Suppose that to raise the funds for the initial investment the firm borrows $40,000 at
the risk-free rate and issues new equity to cover the remainder. In this situation, the cash
flow that equity holders will receive in one year in a strong economy is closest to:
A) $117,000.
B) $75,000.
C) $50,000.
D) $0.

17) Suppose that to raise the funds for the initial investment the firm borrows $40,000 at
the risk-free rate and issues new equity to cover the remainder. In this situation, the value
of the firm's levered equity from the project is closest to:
A) $0.
B) $50,000.
C) $90,000.
D) $40,000.

18) Suppose that to raise the funds for the initial investment the firm borrows $40,000 at
the risk-free rate and issues new equity to cover the remainder. In this situation, the cost of
capital for the firm's levered equity is closest to:
A) 23%.
B) 25%.
C) 15%.
D) 18%.

19) Suppose that to raise the funds for the initial investment the firm borrows $45,000 at
the risk-free rate and issues new equity to cover the remainder. In this situation, calculate
the value of the firm's levered equity from the project. What is the cost of capital for the
firm's levered equity?

20) Two separate firms are considering investing in this project. Firm Unlevered plans to
fund the entire $80,000 investment using equity, while firm Levered plans to borrow
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$45,000 at the risk-free rate and use equity to finance the remainder of the initial
investment. Construct a table detailing the percentage returns to the equity holders of both
the levered and unlevered firms for both the weak and strong economy.

21) Two separate firms are considering investing in this project. Firm Unlevered plans to
fund the entire $80,000 investment using equity, while firm Levered plans to borrow
$45,000 at the risk-free rate and use equity to finance the remainder of the initial
investment. Calculate the expected returns for both the levered and unlevered firms.

22) Two separate firms are considering investing in this project. Firm Unlevered plans to
fund the entire $80,000 investment using equity, while firm Levered plans to borrow
$45,000 at the risk-free rate and use equity to finance the remainder of the initial
investment. Calculate the risk premiums for both the levered and unlevered firms.

14.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

Use the following information to answer the question(s) below.

Galt Industries has 50 million shares outstanding and a market capitalization of $1.25
billion. It also has $750 million in debt outstanding. Galt Industries has decided to delever
the firm by issuing new equity and completely repaying all the outstanding debt. Assume
perfect capital markets.

1) The number of shares that Galt must issue is closest to:

A) 15 million.
B) 25 million.
C) 30 million.
D) 40 million.

2) Suppose you are a shareholder in Galt industries holding 100 shares, and you disagree
with this decision to delever the firm. You can undo the effect of this decision by:
A) borrowing $1500 and buying 60 shares of stock.
B) selling 32 shares of stock and lending $800.
C) borrowing $1000 and buying 40 shares of stock.
D) selling 40 shares of stock and lending $1000.

3) Suppose you are a shareholder in Galt industries holding 600 shares, and you disagree
with this decision to delever the firm. You can undo the effect of this decision by:
A) borrowing $6000 and buying 240 shares of stock.
B) selling 240 shares of stock and lending $6000.
C) borrowing $9000 and buying 360 shares of stock.
D) selling 360 shares of stock and lending $9000.

Use the following information to answer the question(s) below.

d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are
currently trading at $20 per share. Last month, d'Anconia announced that it will change its
capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus
another $200 million in cash that d'Anconia already has, will be used to repurchase existing
shares of stock. Assume that capital markets are perfect.

4) The market capitalization of d'Anconia Copper before this transaction takes place is
closest to:
A) $800 million.
B) $900 million.
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C) $1100 million.
D) $1200 million.

5) The market capitalization of d'Anconia Copper after this transaction takes place is
closest to:
A) $800 million.
B) $900 million.
C) $1100 million.
D) $1200 million.

6) At the conclusion of this transaction, the number of shares that d'Anconia Copper will
repurchase is closest to:
A) 5 million.
B) 15 million.
C) 20 million.
D) 40 million.

7) At the conclusion of this transaction, the number of shares that d'Anconia Copper will
have outstanding is closest to:
A) 5 million.
B) 15 million.
C) 20 million.
D) 40 million.

8) At the conclusion of this transaction, the value of a share of d'Anconia Copper will be
closest to:
A) $18.33.
B) $20.00.
C) $25.00.
D) $27.50.

9) Suppose you are a shareholder in d'Anconia Copper holding 300 shares, and you
disagree with the decision to lever the firm. You can undo the effect of this decision by:
A) borrowing $2000 and buying 100 shares of stock.
B) selling 100 shares of stock and lending $2000.
C) borrowing $1200 and buying 60 shares of stock.
D) selling 60 shares of stock and lending $1200.

10) Suppose you are a shareholder in d'Anconia Copper holding 500 shares, and you
disagree with the decision to lever the firm. You can undo the effect of this decision by:
A) borrowing $2000 and buying 100 shares of stock.
B) selling 100 shares of stock and lending $2000.
C) borrowing $1200 and buying 60 shares of stock.
D) selling 60 shares of stock and lending $1200.

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