Exam 14: Capital Structure in a Perfect Market

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 firm.

Use the following information to answer the question(s)below. Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%. -Consider the following equation: E + D = U = A The A in this equation represents:

Use the information for the question(s)below. Assume that Rose Corporation's (RC)EBIT is not expected to grow in the future and that all earnings are paid out as dividends. RC is currently an all equity firm. It expects to generate earnings before interest and taxes (EBIT)of $6 million over the next year. Currently RC has 5 million shares outstanding and its stock is trading for a price of $12.00 per share. RC is considering borrowing $12 million at a rate of 6% and using the proceeds to repurchase shares at the current price of $12.00. -Show mathematically that the stock price of RC won't change following the debt issuance and share repurchase.

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

Use the information for the question(s)below. Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%. -Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as with. You have $5000 of your own money to invest and you plan on buying With stock. Using homemade (un)leverage you invest enough at the risk-free rate so that the payoff of your account will be the same as a $5000 investment in Without stock? The number of shares of With stock you purchased is closest to:

Use the information for the question(s)below. Consider two firms: firm Without has no debt, and firm With has debt of $10,000 on which it pays interest of 5% per year. Both companies have identical projects that generate free cash flows of $1000 or $2000 each year. Suppose that there are no taxes, and after paying any interest on debt, both companies use all remaining cash free cash flows to pay dividends each year. -Fill in the table below showing the payments debt and equity holders of each firm will receive given each of the two possible levels of free cash flows:

Use the information for the question(s)below. Consider two firms: firm Without has no debt, and firm With has debt of $10,000 on which it pays interest of 5% per year. Both companies have identical projects that generate free cash flows of $1000 or $2000 each year. Suppose that there are no taxes, and after paying any interest on debt, both companies use all remaining cash free cash flows to pay dividends each year. -Suppose that Rearden Metal currently has no debt and has an equity cost of capital of 12%. Rearden is considering borrowing funds at a cost of 6% and using these funds to repurchase existing shares of stock. Assume perfect capital markets. If Taggart borrows until they achieved a debt -to-equity ratio of 50%, then Rearden's levered cost of equity would be closest to:

Use the information for the question(s)below. Luther Industries has no debt, a total equity capitalization of $20 billion, and a beta of 1.8. Included in Luther's assets are $4 billion in cash and risk-free securities. -What is Luther's enterprise value?

Use the information for the question(s)below. Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share. -Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to employees valued at $2 billion. After the repurchase how many shares will Luther have outstanding?

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. -Which of the following statements is FALSE?

Use the following information to answer the question(s)below. Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%. -Which of the following statements is FALSE?

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%. -Suppose that you borrow only $45,000 in financing the project. According to MM proposition II, calculate the firm's equity cost of capital.

Use the information for the question(s)below. Rockwood Enterprises is currently an all equity firm and has just announced plans to expand their current business. In order to fund this expansion, Rockwood will need to raise $100 million in new capital. After the expansion, Rockwood is expected to produce earnings before interest and taxes of $50 million per year in perpetuity. Rockwood has already announced the planned expansion, but has not yet determined how best to fund the expansion. Rockwood currently has 16 million shares outstanding and following the expansion announcement these shares are trading at $25 per share. Rockwood has the ability to borrow at a rate of 5% or to issue new equity at $25 per share. -If Rockwood finances their expansion by issuing $100 million in debt at 5%, what will Rockwood's cost of equity capital be?

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%. -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:

Use the information for the question(s)below. Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share. -With perfect capital markets, what is the market price per share of Luther's stock after the share repurchase?

Consider the following equation: β_U = β_E + β_D The term β_D in the equation is:

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. -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:

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%. -Suppose that you borrow $60,000 in financing the project. According to MM proposition II, the firm's equity cost of capital will be closest to:

Use the information for the question(s)below. You are evaluating a new project and need an estimate for your project's beta. You have identified the following information about three firms with comparable projects: -The unlevered beta for Lincoln is closest to:

Use the information for the question(s)below. Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share. -Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to employees valued at $2 billion. The market value of Luther's non-cash assets is closest to: