# Acme inc is an all equity firm acme can issue debt to

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64. Acme, Inc. is an all-equity firm. Acme can issue debt to debtholders whose personal tax rate (T d ) is 50%. Its shareholders' personal tax rate (T e ) is 20%. Acme pays corporate taxes on its net income but otherwise operates in a perfect capital market environment. Acme has a perpetual expected cash inflow each year () of \$150M (M = million). Its corporate tax rate (T) is 37.5% and its unleveraged cost of capital (r) is 15%. Now suppose the firm can borrows at a personal before-taxes required return (r d ) of 10% and its before-tax payment (CPN) is \$50M. Debt will increase the firm’s cost of borrowing. Its required rate of return on leveraged equity (r L ) will be 20%. What is Acme’s leveraged equity value (E L )? a. \$242M b. \$246M c. \$250M d. \$254M [ ANSWER: Acme’s leveraged equity value is: E L = (1 - T e )(1 – T)( - CPN) / r L = (1 – 0.2)(1 – 0.375)(\$150 - \$50) / 0.2 = \$50 / 0.2 = \$250M .] x 65. Acme, Inc. is an all-equity firm. Acme can issue debt to debtholders whose personal tax rate (T d ) is 50%. Its shareholders' personal tax rate (T e ) is 20%. Acme pays corporate taxes on its net income but otherwise operates in a perfect capital market environment. Acme has a perpetual expected cash inflow each year () of \$150M (M = million). Its corporate tax rate (T) is 37.5% and its unleveraged cost of capital (r) is 15%. Now suppose the firm can borrows at a personal before-taxes required return (r d ) of 10% and its before-tax payment (CPN) is \$50M. Debt will increase the firm’s cost of borrowing. Its required rate of return on leveraged equity (r L ) will be 20%. What is Acme’s leveraged firm value (V L )? [

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(1 - T e )(1 – T)( - CPN) / r L = (1 – 0.2)(1 – 0.375)(\$150 - \$50) / 0.2 = \$50 / 0.2 = \$250M . Acme’s after-tax borrowing is: D = (1 - T d )CPN / r D = (1 – 0.5)(\$50M) / 0.1 = 0.1(\$250) / 0.1 = \$250M . Thus, V L = E L + D = \$250M + \$250M = \$500M .] c 66. The Pecking Order Theory of capital structure posits that firms will only issue equity as a last resort. Reasons include the cost of equity financing and the negative signaling that can accompany stock offerings due to investors’ suspicion about firm’s issuing stock when it is overvalued. Exquisite, Inc. has 20M (M = million) shares outstanding at \$10 per share. Exquisite announces a new offering of 10M new shares at \$9.50 per share. Its issue costs are 10% of the offering value and that the announcement of a stock offering causes its outstanding stock value to fall 6%. How much of the fall in price can be explained by issue costs? [ \$9.5M. This cost will be spread out over 20M outstanding shares. The cost per share = \$9.5M / 20M = \$0.475 per share. The stock price should fall to \$10 - \$0.475 = \$9.525 based on issue costs alone. The market response causes the shares to fall 6% or 0.06(\$10) = \$0.60. Thus, \$0.475 / \$0.6 = 0.79167 or about 79.17% of the fall can be explained by issue costs .] b
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