Question 14 Cabernet Ltd and Chardonnay Ltd are two Australian quoted companies

Question 14 cabernet ltd and chardonnay ltd are two

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Question 14 Cabernet Ltd and Chardonnay Ltd are two Australian quoted companies with the same business risk class. Cabernet has a debt to equity ratio of 1:3, its equity has a beta of 1.6, and its irredeemable debt can be assumed to be riskless. Chardonnay is an all-equity financed company. The expected return on the All Ordinaries Index is 16% and the return on Government Stock (and, hence, also the return on Cabernet’s debt) is 10%. Assume that both companies pay out constant annual dividends in perpetuity and that there is no taxation. a. Estimate the beta value of Char donnay’s equity and the overall cost of capital of each company. Comment briefly on the significance of your e and K 0 estimates with respect to the Modigliani and Miller no-tax capital structure hypothesis. b. A small shareholder in Chardonnay has just received his regular dividend of $450. The shareholder has now been offered $3,000 for his shareholding. However, he does not know whether or not to sell his shares as he relies heavily on his annual dividend from the company. Explain how the investor can make himself better off with no change in risk by selling his shares in Chardonnay and investing in Cabernet. What would be his resulting gain? c. A ssuming Cabernet’s debt and equity capital are at their equilibrium value, estimate the equilibrium value of the investor’s shareholding in Chardonnay.
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Question 15 Unicom and Lehman Inc. are identical companies except for their capital structure. Unicom is an unlevered company with $1.5m equity. Lehman uses both (perpetual) debt and equity, its equity worth $0.75m and the cost of debt is 8%. Earnings before interests and taxes of both companies equal $172,000. No taxes. i. Dave holds $60,000 worth of Lehman’s shares. What is the rate of return on his investment. ii. Demonstrate how Dave could generate the same cash flows and rate of return by investing in Unicom. Compare the two situations (part a vs part b). iii. Calculate the cost of equity for Unicom and Lehman. iv. Calculate the WACC for the companies. What principle have you illustrated? Explain. Question 16 ABC Inc., intends to issue $5m of 30-year bonds with a coupon rate of 7 percent. The current market interest rates on bond of similar risk are 6%. The interest rate on the bonds with either be 9% or 5%, with equal probability. a. Calculate the price of the bonds today if they are non-callable. b. Calculate the price of the bonds today if they are callable in one year at $1080. Is the price higher or lower than the one you calculated in part (a)? Explain. Question 17 Company KU earns a perpetual net income of $840,000 per year. KU is all equity financed with 100,000 shares outstanding and a cost of capital of 10%. Assume no taxes. Fanny , an investor who owns 10,000 shares of KU. a. What is the stock price of KU ? b. KU announces its intention to distribute 400,000 of its current net income as cash dividends. How much cash from the dividend policy will Fanny receive? c. If Fanny prefers a different dividend policy with payment of $6 per share. How can Fanny achieve it her own? d. Please compare the value of stock holdings and total wealth of Fanny under the two dividend policies, and briefly explain whether dividend policy is relevant.
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