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Unformatted text preview: University of Pennsylvania The Wharton School FNCE 100 A. Craig MacKinlay PROBLEM SET #6 Fall Term 2005 Capital Structure 1. The XYZ Co. is assessing its current capital structure and its implications for the welfare of its security holders. XYZ currently is financed entirely with common stock, of which 1,000 shares are outstanding. Given the risk of the underlying cash flows (EBIT) generated by XYZ, investors currently require a 20% return on the XYZ common. The company pays out all expected earnings as dividends to common stockholders, and these expected earnings are based on the expected operating earnings (EBIT) generated by the firm’s assets. XYZ estimates that operating income may be either 1,000, 2,000 or 4,200 with respective probabilities of .1, .4 and .5 depending on future economic conditions. Further, the firm expects to produce a level stream of EBIT in perpetuity. Assume that the corporate and personal tax rate is equal to zero. (a) Given the above facts, compute i. the value of the firm, ii. the market value of a common share, iii. the expected earnings per share of common, iv. the return on the common shares under each economic scenario, and v. the firm’s average cost of capital. (b) The president of XYZ has come to the conclusion that shareholders would be better off if the company had equal proportions of debt and equity. He therefore proposes to issue $7,500 of debt at an interest rate of 10% and use the proceeds to repurchase 500 shares of common. Using the arguments of Modigliani and Miller (MM) analyze this proposition by computing i. the new value of the firm, ii. the value of debt, iii. the value of equity, iv. the price of one common share, v. the required rate of return on equity (¯ r e ), and vi. the firm’s average cost of capital. 62 Be sure to give (brief) supporting explanations for your answers for parts (i), (v) and (vi). (c) Using the arguments proposed in the Traditional view, explain (without numbers) the effect of the increased debt in (b) on i. firm value and ii. stock price. What effect, according to the Traditionalists, would the increased debt have on the required return on the common stock? What impact would this have on average cost of capital. (d) Graph: i. the relationship between market value of the firm and the firm’s debt-equity ratio, and ii. the relationship between average cost of capital and the firm’s debt-equity ratio for both the Traditional and the MM case. (e) What does MM’s Proposition II say about the required rate of return on equity? What does the Traditional viewpoints have to say? Graph both of these view- points and briefly explain why they are consistent with the graphs in Questions (d.ii)....
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