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chap017_sm

# Fundamentals of Corporate Finance + Standard & Poor's Educational Version of Market Insight

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CHAPTER 17 Does Debt Policy Matter? Answers to Practice Questions 1. a. The two firms have equal value; let V represent the total value of the firm. Rosencrantz could buy one percent of Company B’s equity and borrow an amount equal to: 0.01 × (D A - D B ) = 0.002V This investment requires a net cash outlay of (0.007V) and provides a net cash return of: (0.01 × Profits) – (0.003 × r f × V) where r f is the risk-free rate of interest on debt. Thus, the two investments are identical. b. Guildenstern could buy two percent of Company A’s equity and lend an amount equal to: 0.02 × (D A - D B ) = 0.004V This investment requires a net cash outlay of (0.018V) and provides a net cash return of: (0.02 × Profits) – (0.002 × r f × V) Thus the two investments are identical. c. The expected dollar return to Rosencrantz’ original investment in A is: (0.01 × C) – (0.003 × r f × V A ) where C is the expected profit (cash flow) generated by the firm’s assets. Since the firms are the same except for capital structure, C must also be the expected cash flow for Firm B. The dollar return to Rosencrantz’ alternative strategy is: (0.01 × C) – (0.003 × r f × V B ) Also, the cost of the original strategy is (0.007V A ) while the cost of the alternative strategy is (0.007V B ). If V A is less than V B , then the original strategy of investing in Company A would provide a larger dollar return at the same time that it would cost less than the alternative. Thus, no rational investor would invest in Company B if the value of Company A were less than that of Company B. 136

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2. When a firm issues debt, it shifts its cash flow into two streams. MM’s Proposition I states that this does not affect firm value if the investor can reconstitute a firm’s cash flow stream by creating personal leverage or by undoing the effect of the firm’s leverage by investing in both debt and equity. It is similar with Carruther’s cows. If the cream and skim milk go into the same pail, the cows have no special value. (If an investor holds both the debt and equity, the firm does not add value by splitting the cash flows into the two streams.) In the same vein, the cows have no special value if a dairy can costlessly split up whole milk into cream and skim milk. (Firm borrowing does not add value if investors can borrow on their own account.) Carruther’s cows will have extra value if consumers want cream and skim milk and if the dairy cannot split up whole milk, or if it is costly to do so. 3. a. The market price of the stock is not affected by the announcement. b. Since the market price of the shares is \$10, the company can buy back: \$160 million/\$10 = 16 million shares c. After the change in capital structure, the market value of the firm is unchanged: Equity + Debt = (9 million × \$10) + \$160 million = \$250 million d. After the change in structure, the debt ratio is: Debt/(Debt + Equity) = \$160 million/\$250 million = 0.64 e. No one gains or loses. (See the answer to the next question.) 4.
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chap017_sm - CHAPTER 17 Does Debt Policy Matter Answers to...

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