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CHAPTER 17

2015022andinaslumpyouareentitledto010 80020502

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Unformatted text preview: the refinancing is: EPSA = [0.08V – (0.05 ´ 0.5 ´ V)]/(0.5 ´ N) = 0.11V/N It follows that earnings per share has increased by 37.5%. g. Before the refinancing, the P/E ratio is 12.5. The price of the common stock is the same before and after the refinancing, but the earnings per share has increased from (0.08V/N) to (0.11V/N). (See Part (f) above.) Thus, the new P/E ratio is 9.09. 14. We make use of the basic relationship: If the company is all­equity­financed and the cost of equity capital (rE) is 18%, then the company cost of capital (rA) is 18%, which will not change as the capital structure changes. In addition, we know that the risk­free rate (rf) is 10% and that Gamma’s debt is risk­free. Thus: D/E 0 1 2 3 rA 0.18 0.18 0.18 0.18 rD 0.10 0.10 0.10 0.10 rE 0.18 0.26 0.34 0.42 D/V 0 0.25 0.50 0.75 rA 0.18 0.18 0.18 0.18 rD 0.10 0.10 0.10 0.10 rE 0.180 0.207 0.260 0.420 15. a. Because the firms are identical except for capital structure, and there are no taxes or other market imperfections, the total values of these companies must be the same. Thus, L’s stock is worth: (\$500 ­ \$400) = \$100. b. If you own \$20 of U’s common stock, you own 4% of the outstanding shares and, thus, are entitled to (0.04 ´ \$150) = \$6 if there is a boom and (0.04 ´ \$50) = \$2 if there is a slump. The equivalent investment is to purchase 4% of L’s outstanding stock, which will cost (0.04 ´ \$100) = \$4, and to invest \$16 at the risk­free rate. The t...
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