Autumn 2005- TBS 907- Tutorial 3 - Capital Structure with Solutions

Autumn 2005 TBS - TBS 907 AUTUMN 2005 TUTORIAL 3 CAPITAL STRUCTURE SOLUTIONS QUESTION 1(a Operating Earnings Debenture Interest Laurel $180,000

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TBS 907 - AUTUMN 2005 TUTORIAL 3- CAPITAL STRUCTURE SOLUTIONS QUESTION 1 (a) Laurel Hardy Operating Earnings $180,000 $180,000 Debenture Interest 36,000 $180,000 $144,000 Laurel is value at $2 m while Hardy is valued at $1.8m ($1.2m equity and $600k debt). In an MM world both companies should have the same value as they have identical earnings streams in terms of value and risk. If we assume prefect capital markets were there are no taxes or transaction costs and that personal debt is a perfect substitute for corporate debt, then Roach should sell his interest in Laurel and invests in Hardy while keeping his level of financial risk the same. Sell 6% of Laurel for $120,000 Invest in : Hardy Equity $80,000 Hardy Debt $40,000 $120,000 By investing in equity and debt in proportion to their market value, financial risk is nil, i.e. the same as Laurel. Before income was 6% of $180,000 $10,800 After Income is: equity- 8/120 x $144,000 9,600 Debt – 6% of $40,000 2,400 $12,000 I.e. income has increase by $1,200 while risk remains unchanged. (b) The arbitrage opportunity will gradually diminish as the value of Laurel will decrease and the value of Hardy increases until an equilibrium point has been reached. (c) Rational investors would arbitrage in this situation, moving from the higher valued firm to the lower valued firm, thus increasing their income for the same investment, whilst holding their level of risk constant. This process would continue until all the firms in the same risk class would sell for the same total rate of return irrespective of how they were financed. Thus, in a such a world WACC is a constant and is not affected by changes in capital structure, and projects of the same risk class can be appraised using the current WACC ( including the cost of equity in an all equity firm) irrespective of the way in which the project is to be financed. This result depends, however, on the restrictive assumptions TBS 907- A UTUMN 2005- T UTORIAL 3- CAPITAL STRUCTURE P AGE 1 OF 5
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mentioned in (a) and whether relaxation of these assumptions has a significant impact on the conclusion QUESTION 2 An investor who owns 2% of L has the following capital structure: He owns 2% of shares = $7000 He is responsible for 25 of debt = $4000 His current return form investment in L = 2% of $70,000 = $1,400 There is an arbitrage situation as L is overvalued as compared to U and an investor could benefit from selling his investment in L and investing in U while keeping his capital structure unaltered.
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This note was uploaded on 07/10/2009 for the course FIN FIN taught by Professor Dr. during the Spring '09 term at Baptist College of Health Sciences.

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Autumn 2005 TBS - TBS 907 AUTUMN 2005 TUTORIAL 3 CAPITAL STRUCTURE SOLUTIONS QUESTION 1(a Operating Earnings Debenture Interest Laurel $180,000

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