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.

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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- Fall '15
- Finance, Corporate Finance, Sligo