Spring 2005 -Questions for TBS 907 Tutorial 3- Capital S (1)

Spring 2005 -Questions for TBS 907 Tutorial 3- Capital S...

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TBS 907- TUTORIAL 3 CAPITAL STRUCTURE QUESTION 1 Hall Roach owns 6% of the equity in an unlevered company called Laurel Ltd. The total market value of Laurel's shares is $2,000,000 and the expected annual operating earnings are $180,000 into perpetuity. It has recently come to Roach's attention that there is another firm, Hardy Ltd, which is identical in every respect to Laurel except that its capital structure is 2/3 equity: 1/3 debt. The expected annual operating earnings of Hardy are also $180,000 (before the deduction of interest on debt) and the current market value of its equity is $1,200,000. Hardy Ltd's outstanding debt takes the form of $600,000 of 6% debentures, currently traded at par. Both companies pay out all available earnings as dividends. Required: (a) Advise Roach how he could increase his current dividend expectation without changing his risk. In giving your advice indicate any assumptions you would need to make. (b) What will happen if other investors do the same? (c) What are the implications of the transactions all rational investors would make in a situation such as this and why are they important for capital budgeting? QUESTION 2 Given the following data, a suitable arbitrage opportunity for an investor with a 2 per cent share in Company L would be to: Company U Company L Earnings before interest $0.1 million p.a. $0.1 million p.a. Interest on debt $0 $0.03 million p.a. Income available to s/h $0.1 million p.a. $0.07 million p.a. Cost of equity capital 19 per cent 20 per cent Market value of shares $526,315.80 $0.35 million Market value of debt $0 $0.2 million Total market value $526,315.80 $550,000 TBS 907- S PRING 2005- T UTORIAL 3- C APITAL S TURCTURE P AGE 1 OF 5
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QUESTION 3 Company A and Company B, which have the same business risk, are identical in every aspect except that A has no debt while B has a $2 million loan at an interest rate of 8 per cent. Assume that the valuation of the two companies is as follows: Company A Company B Earnings before interest 700,000 700,000 Interest on debt $0 160,000 Income available to s/h 700,000 540,000 Cost of equity capital 0.14 0.16 Market value of shares 5,000,000 3,375,000 Market value of debt $0 2,000,000 Total market value 5,000,000 5,375,000 Assume that an investor owns $10,000 worth of Company B’ shares. Show the process and the amount by which the investor could increase her income by the use of arbitrage. Also further assume that you do not have the market value of equity for Company B and
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Spring 2005 -Questions for TBS 907 Tutorial 3- Capital S...

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