CHAPTER_13 - CHAPTER 13 Does Debt Policy Matter Answers to...

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CHAPTER 13 Does Debt Policy Matter? Answers to Problem Sets 1. Note the market value of Copperhead is far in excess of its book value: Ms. Kraft owns .625% of the firm, which proposes to increase common stock to $17 million and cut short-term debt. Ms. Kraft can offset this by (a) borrowing .00625 X 1,000,000 = $6,250, and (b) buying that much more Copperhead stock. 2. a. % = 12.5%; = 20% b. 12.5% c. E/P = 20%; P/E = 5 d. $50 e. .5 X + .5 X 0 = 1.0; = 2.0. 3. Expected return on assets is r A = .08 X 30/80 + .16 X 50/80 = .13. The new return on equity will be r E = .13 + (20/60)(.13 - .08) = .147. 4. a. b.
.8 = (.25 x 0) + (.75 x β E ) β E = 1.07 5. a. True b. True (as long as the return earned by the company is greater than the interest payment, earnings per share increase, but the PyE falls to reflect the higher risk). c. False (the cost of equity increases with the ratio D/E). d. False (the formula r E = r A + (D/E)(r A - r D ) does not require r D to be constant). e. False (debt amplifies variations in equity income). f. False (value increases only if clientele is not satisfied). 6. a. r A = .15, r E = .175 b. β A = .6 (unchanged), β D = .3, β E = .9. 7. See Figure 13.3. 8. Currently r A = r E = .14, or 14%. From proposition 2 the leverage causes r E to increase to r E = r A + (r A – r D )(D/E) = .14 + (.14 - .095) X (45/55) = .1768, or 17.68% After-tax WACC = .095 X (1 - .40) X .45 + .1768 X .55 = .1229, or 12.29%. 9. a. The two firms have equal value; let V represent the total value of the firm. Rosencrantz could buy one percent of Company B’s equity and borrow an amount equal to: 0.01  (D A - D B ) = 0.002V This investment requires a net cash outlay of (0.007V) and provides a net cash return of: (0.01  Profits) – (0.003  r f  V) where r f is the risk-free rate of interest on debt. Thus, the two investments are identical.
b. Guildenstern could buy two percent of Company A’s equity and lend an amount equal to: 0.02  (D A - D B ) = 0.004V This investment requires a net cash outlay of (0.018V) and provides a net cash return of: (0.02  Profits) – (0.002  r f  V) Thus the two investments are identical. c. The expected dollar return to Rosencrantz’ original investment in A is: (0.01  C) – (0.003  r f  V A ) where C is the expected profit (cash flow) generated by the firm’s assets. Since the firms are the same except for capital structure, C must also be the expected cash flow for Firm B. The dollar return to Rosencrantz’ alternative strategy is: (0.01  C) – (0.003  r f  V B ) Also, the cost of the original strategy is (0.007V A ) while the cost of the alternative strategy is (0.007V B ). If V A is less than V B , then the original strategy of investing in Company A would provide a larger dollar return at the same time that it would cost less than the alternative. Thus, no rational investor would invest in Company B if the value of Company A were less than that of Company B.

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