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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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This note was uploaded on 04/26/2013 for the course MATH 289Q taught by Professor Jamesbridgeman during the Fall '04 term at UConn.
 Fall '04
 JAMESBRIDGEMAN
 Math

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