as372w10a5soln

# as372w10a5soln - Assignment #5 Solution (Actsc 372) Total...

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Assignment #5 Solution (Actsc 372) Total marks: 50 Q1. (5 Marks) False. The stock price would have adjusted before the founder’s death only if investors had perfect forecasting ability. The 12.5 percent increase in the stock price after the founder’s death indicates that either the market did not anticipate the death or that the market had anticipated it imperfectly. However, the market reacted immediately to the new information, implying efficiency. It is interesting that the stock price rose after the announcement of the founder’s death. This price behavior indicates that the market felt he was a liability to the firm. Q2 (10 Marks) a. A firm’s debt–equity ratio is the market value of the firm’s debt divided by the market value of a firm’s equity. The market value of Acetate’s debt \$9 million, and the market value of Acetate’s equity is \$30 million. Debt–Equity Ratio = Market Value of Debt / Market Value of Equity = \$9 million / \$30 million = 0.03 Therefore, Acetate’s Debt–Equity Ratio is 30 %. b. The cost of Acetate’s equity is: r S = r f + β S {E(r m ) – r f } = 0.07 + 0.85( 0.21 – 0.07) = 0.189 r wacc = {B / (B+S)} r B + {S / (B+S)}r S = (\$9 million / \$39 million)(0.14) + (\$30 million / \$39 million)(0.189) = (0.23)(0.14) + (.77)(0.189) = 0.1777 Therefore, Acetate’s weighted average cost of capital is 17.77%. c. According to Modigliani–Miller Proposition II (No Taxes): r S = r 0 + (B/S)(r 0 – r B ) Thus: 0.189= r 0 + (9/30)(r 0 – 0.14) Solving for r 0: r 0 = 0.1777 Therefore, the cost of capital for an otherwise identical all–equity firm is 17.77%. This is consistent with Modigliani–Miller’s proposition that, in the absence of taxes, the cost of capital for an all–equity firm is equal to the weighted average cost of capital of an otherwise identical levered firm. Q3. (25 Marks) a. Since the firm expects to earn \$810,000 per year in perpetuity and the appropriate discount rate to its unlevered equity holders is 13%, the market value of Strom’s assets is equal to a perpetuity of \$810,000 per year, discounted at 13%. Therefore, the market value of Strom’s assets before the buyout is \$6,230,769.23 (= \$810,000 / 0.13).

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Strom’s market–value balance sheet prior to the announcement of the buyout is: Assets = 6,23 0,769.23 \$ Debt = - \$ Equity = 6,23 0,769.23 \$ Total Assets = 6,23 0,769.23 \$ Total D + E = 6,23 0,769.23 \$ Strom, Inc. b.
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## This note was uploaded on 06/21/2010 for the course ACTSC 5255 taught by Professor Tan,kens during the Spring '10 term at Waterloo.

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as372w10a5soln - Assignment #5 Solution (Actsc 372) Total...

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