FINM2415 Corporate Finance Tutorial Questions 3
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Tutorial Questions 3. Capital Structure in a Perfect Market
Note:
This topic has more questions than can be covered in a 2 hour session. The questions to be covered by your tutor are indicated by an asterisk (*); the rest should be viewed as extra practice problems.
MMI:
14- 1*. A firm has only one project that requires an initial investment of $100,655. The project free cash flows in one year is either $137,022 or $188,017, with each outcome being equally likely. The project’s cost of capital is 20%. The risk-free interest rate is 5%.
a. What is the NPV of this project? What is the total asset value of this firm after this investment? What is the firm value after this investment?
b. 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. How much money can be raised in this way—that is, what is the market value of the unlevered equity? What is the firm value?
c. Suppose the initial $100,655 is instead raised by borrowing at the risk-free interest rate. What are the cash flows of the levered equity in one year, and what is its initial value according to MM? What is the firm value in this case?
d. Does MMI theory hold in this case?
14-3*. Acort Industries owns assets that will have a 75% probability of having a market value of $48 million one year from now. There is a 25% chance that the assets will be worth only $18 million. The current risk-free rate is 5%, and Acort’s assets have a cost of capital of 10%.
a. If Acort isunlevered, what is the current market value of its equity?
b. Suppose instead that Acort has debt with a face value of $18 million due in one year. According to MM, what is the value of Acort’s equity in this case?
c. What is the expected return of Acort’s equity without leverage? What is the expected return of Acort’s equity with leverage?
d. What is the lowest possible realized return of Acort’s equity with and without leverage?
14-4. Wolfrum Technology (WT) has no debt. Its assets will be worth $444 million in one year if the economy is strong, but only $226 million in one year if the economy is weak. Both events are equally likely. The market value today of its assets is $257 million.
a. What is the expected return of WT stock without leverage?
b. Suppose the risk-free interest rate is 5%. If WT borrows $52 million today at this rate and uses the proceeds to buy back its equity, what will be the market value of its equity just after this transaction, according to MM?
c. What is the expected return of WT stock after the transaction in part (b)?
14-6*. Suppose Alpha Industries and Omega Technology have identical assets that generate identical cash flows. Alpha Industries is an all-equity firm, with 14 million shares outstanding that trade for a price of $24 per share. Omega Technology has 22 million shares outstanding as well as debt of $100 million.
a. According to MM Proposition I, what is the stock price for Omega Technology?
b. Suppose Omega Technology stock currently trades for $15 per share. What arbitrage opportunity is available? What assumptions are necessary to exploit this opportunity?
MMII:
14- 10. 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.”
14- 11*. A firm has only one investment project requiring an initial investment of $800 this year, the project will generate cash flows of either $1400 or $900 next year, depending on whether the economy is strong or weak, respectively. There is 75% chance that the economy is strong. The project cost of capital is 20%.
a. What is theNPV of this project?
b. If the project is financed using all equity. What is the value of the firm – that is, how much would investors be willing to pay for the firm’ unlevered equity? What is the cost of unlevered equity?
c. If the project is financed using both debt and equity where the firm can borrow $750 at the risk-free rate of 5%:
c1. According to MM Proposition I, what is the value of the equity? What are the cash flows to securities holders in year 1 if the economy is strong? if the economy is weak?
c2. What is the return of the equity in each case? What is its expected return?
c3. What is the debt-equity ratio of the firm in this case?
c4. What is the firm’s WACC in this case? Is the firm’s WACC equal to the cost of unlevered equity in Part (b)?
14- 12. Hardmon Enterprises is currently an all-equity firm with an expected return of 12%. 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 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?
14- 14*. Global Pistons (GP) has common stock with a market value of $470 million and debt with a value of $299 million. Investors expect a 13% return on the stock and a 5% return on the debt. Assume perfect capital markets.
a. Suppose GP issues $299 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 $71 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 in part (i)?
14- 15. Hubbard Industries is an all-equity firm whose shares have an expected return of 10.9%. Hubbard does a leveraged recapitalization by issuing debt and repurchasing stock until its debt-equity ratio is 0.66. Due to the increased risk, shareholders now expect a return of 17.1%. Assuming there are no taxes and Hubbard’s debt is risk- free, what is the interest rate on the debt?
14- 16. Hartford Mining has 90 million shares that are currently trading for $2 per share and $160 million worth of debt. The debt is risk free and has an interest rate of 4%, and the expected return of Hartford stock is 11%. Suppose a mining strike causes the price of Hartford stock to fall 25% to $1.50 per share. The value of the risk-free debt is unchanged. Assuming there are no taxes and the risk (unlevered beta) of Hartford’s assets is unchanged, what happens to Hartford’s equity cost of capital?
2023-08-24