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Unformatted text preview: rowings. The net cash flow from the investment in Veblen will be: Net cash flow from Veblen investment = $20,000 – .06($53,400) = $16,796 For the same initial cost, the investment in Veblen produces a higher dollar return. b. Both of the two strategies have the same initial cost. Since the dollar return to the investment in Veblen is higher, all investors will choose to invest in Veblen over Knight. The process of investors purchasing Veblen’s equity rather than Knight’s will cause the market value of Veblen’s equity to rise and/or the market value of Knight’s equity to fall. Any differences in the dollar returns to the two strategies will be eliminated, and the process will cease when the total market values of the two firms are equal. Before the announcement of the stock repurchase plan, the market value of the outstanding debt is $4,300,000. Using the debtequity ratio, we can find that the value of the outstanding equity must be: Debtequity ratio = B / S .40 = $4,300,000 / S S = $10,750,000 The value of a levered firm is equal to the sum of the market value of the firm’s debt and the market value of the firm’s equity, so: VL = B + S VL = $4,300,000 + 10,750,000 VL = $15,050,000 According to MM Proposition I without taxes, changes in a firm’s capital structure have no effect on the overall value of the firm. Therefore, the value of the firm will not change after the announcement of the stock repurchase plan 23. a. 359 b. The expected return on a firm’s equity is the ratio of annual earnings to the market value of the firm’s equity, or return on equity. Before the restructuring, the company was expected to pay interest in the amount of: Interest payment = .10($4,300,000) = $430,000 The return on equity, which is equal to RS, will be: ROE = RS = ($1,680,000 – 430,000) / $10,750,000 RS = .1163 or 11.63% c. According to ModiglianiMiller Proposition II with no taxes: RS = R0 + (B/S)(R0 – RB) .1163 = R0 + (.40)(R0 – .10) R0 = .1116 or 11.16% This problem can also be solved in the following way: R0 = Earnings before interest / VU According to ModiglianiMiller Proposition I, in a world with no taxes, the value of a levered firm equals the value of an otherwiseidentical unlevered firm. Since the value of the company as a levered firm is $15,050,000 (= $4,300,000 + 10,750,000) and since the firm pays no taxes, the value of the company as an unlevered firm is also $15,050,000 million. So: R0 = $1,680,000 / $15,050,000 R0 = .1116 or 11.16% d. In part c, we calculated the cost of an allequity firm. We can use ModiglianiMiller Proposition II with no taxes again to find the cost of equity for the firm with the new leverage ratio. The cost of equity under the stock repurchase plan will be: RS = R0 + (B/S)(R0 – RB) RS = .1116 + (.50)(.1116 – .10) RS = .1174 or 11.74% 360 24. a. The expected return on a firm’s equity is the ratio of annual aftertax earnings to the market value of the firm’s equity. The amount the firm must pay each year in taxes will be: Taxes = .40($1,800,000) = $720,000 So, the return on the unlevered equity will be: R0 = ($1,800,000 – 720,000) / $9,500,000 R0 = .1137 or 11.37% Notice that perpetual annual earnings of $1,080,000, discounted at 11.37 percent, yields the market value of the firm’s equity b. The company’s market value balance sheet before the announcement of the debt issue is: Debt $9,500,000 Equity $9,500,000 Total D&E 0 $9,500,000 $9,500,000 Assets Total assets The price per share is simply the total market value of the stock divided by the shares outstanding, or: Price per share = $9,500,000 / 600,000 = $15.83 c. ModiglianiMiller Proposition I states that in a world with corporate taxes: VL = VU + TCB When Green announces the debt issue, the value of the firm will increase by the present value of the tax shield on the debt. The present value of the tax shield is: PV(Tax Shield) = TCB PV(Tax Shield) = .40($3,000,000) PV(Tax Shield) = $1,200,000 Therefore, the value of Green Manufacturing will increase by $1,200,000 as a result of the debt issue. The value of Green Manufacturing after the repurchase announcement is: VL = VU + TCB VL = $9,500,000 + .40($3,000,000) VL = $10,700,000 Since the firm has not yet issued any debt, Green’s equity is also worth $10,700,000. 361 Green’s market value balance sheet after the announcement of the debt issue is: Old assets PV(tax shield) Total assets d. $9,500,000 Debt 1,200,000 Equity $10,700,000 Total D&E – $10,700,000 $10,700,000 The share price immediately after the announcement of the debt issue will be: New share price = $10,700,000 / 600,000 = $17.83 e. The number of shares repurchased will be the amount of the debt issue divided by the new share price, or: Shares repurchased = $3,000,000 / $17.83 = 168,224.30 The number of shares outstanding will be the current number of shares minus the number of shares repurchased, or: New shares outstanding = 600,000 – 168,224.30 = 431,775.70 f. The share price will remain the same after restructuring takes place. The total market value of...
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 Spring '10
 eshmalwi
 Finance, Corporate Finance

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