Topic 3

Chapter 16: Questions and Problems 19: MM Proposition / with Taxes

The Maxwell Company is financed entirely with equity. The company is considering a loan of $1.8 million. The loan will be repaid in equal installments over the next two years, and it has an interest rate of 8 percent. The company's tax rate is 35 percent. According to MM Proposition I with taxes, what would be the increase in the value of the company after the loan?

Questions and Problems 20: MM Proposition without Taxes

Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all-equity firm, has 15,000 shares of stock outstanding, currently worth $30 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta's debt is $65,000, and its cost of debt is 9 percent. Each firm is expected to have earnings before interest of $75,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 9 percent per year.

a. What is the value of Alpha Corporation?

b. What is the value of Beta Corporation?

c. What is the market value of Beta Corporation's equity?

d. How much will it cost to purchase 20 percent of each firm's equity?

e. 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 percent of Alpha's equity and replicates both the cost and dollar return of purchasing 20 percent of Beta's equity.

g. Is Alpha's equity more or less risky than Beta's equity? Explain.

Questions and Problems 22: Homemade Leverage

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 $14 million. Financial information for the two firms appears here. All earnings streams are perpetuities. Neither firm pays taxes. Both firms distribute all earnings available to common stockholders immediately.

a. An investor who can borrow at 6 percent per year wishes to purchase 5 percent of Knight's equity. Can he increase his dollar return by purchasing 5 percent of Veblen's equity if he borrows so that the initial net costs of the two strategies are the same?

b. Given the two investment strategies in (a), which will investors choose? When will this process cease?

Questions and Problems 24: Stock Value and Leverage

Green Manufacturing, Inc., plans to announce that it will issue $2 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 6 percent. Green is currently an all-equity firm worth $6.3 million with 400,000 shares of common stock outstanding. After the sale of the bonds, Green will maintain the new capital structure indefinitely. Green currently generates annual pretax earnings of $1.5 million. This level of earnings is expected to remain constant in perpetuity. Green is subject to a corporate tax rate of 40 percent.

a. What is the expected return on Green's equity before the announcement of the debt issue?

b. Construct Green's market value balance sheet before the announcement of the debt issue. What is the price per share of the firm's equity?

c. Construct Green's market value balance sheet immediately after the announcement of debt issue.

d. What is Green's stock price per share immediately after the repurchase announcement?

e. How many shares will Green repurchase as a result of the debt issue? How many shares of common stock will remain after the repurchase?

f. Construct the market value balance sheet after the restructuring.

g. What is the required return on the Green's equity after the restructuring?