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Wolfrum Technology (WT) has no debt. Its assets will be worth $464 million one year from now if the

economy is strong, but only $229 million in one year if the economy is weak. Both events are equally

likely. The market value today of its assets is $276 million.

b. Suppose the risk-free interest rate is 5 %. If WT borrows $53 million today at this rate and uses the

proceeds to pay an immediate cash dividend, what will be the market value of its equity just after the

dividend is paid, according to MM?

c. What is the expected return of WT stock after the dividend is paid in part (b)?

3

Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $ 6 comma 000 on which it

pays interest of 10 % each year. Both companies have identical projects that generate free cash flows of

$ 6 comma 400 or $ 6 comma 500 each year. After paying any interest on debt, both companies use all

remaining free cash flows to pay dividends each year.

a. In the table below, fill in the debt payments for each firm and the dividend payments the equity

holders of each firm will receive given each of the two possible levels of free cash flows.

b. Suppose you hold 10 % of the equity of ABC. What is another portfolio you could hold that would

provide the same cash flows?

c. Suppose you hold 10 % of the equity of XYZ. If you can borrow at 10 %, what is an alternative strategy

that would provide the same cash flows?

a. In the table below, fill in the debt payments for each firm and the dividend payments the equity

holders of each firm will receive given each of the two possible levels of free cash flows. (Round all

answers to the nearest dollar.)

$ 70.00 plus left parenthesis $ 645.00 comma $ 690.00 right parenthesis equals left parenthesis $ 715.00

comma $ 760.00 right parenthesis$70.00+($645.00, $690.00)=($715.00, $760.00)

c. You want the cash flows of the levered firm to equal the cash flows of the unlevered firm. To calculate,

use the following formula:

Levered equity equals Unlevered equity plus BorrowingLevered equity=Unlevered equity+Borrowing

Therefore, an equivalent portfolio to owning

10 %10%

of XYZ equity is to borrow an amount equal to

10 %10%

of the levered firm's (XYZ) debt,

$690.00690.00

for an interest payment of:

Amount Borrowed times Interest rate equals $ 700 times 10 % equals $

70.00Amount Borrowed×Interest rate=$700×10%=$70.00

and buy

10 %10%

of the unlevered firm's equity (ABC), and receive:

left parenthesis $ 715.00 comma $ 760.00 right parenthesis minus $ 70.00 equals left parenthesis $

645.00 comma $ 690.00 right parenthesis($715.00, $760.00)−$70.00=($645.00, $690.00)

Question is complete.

4

Schwartz Industry is an industrial company with 94.8 million shares outstanding and a market

capitalization (equity value) of $ 3.69 billion. It has $1.45 billion of debt outstanding. Management have

decided to delever the firm by issuing new equity to repay all outstanding debt.

b. Suppose you are a shareholder holding 100 shares, and you disagree with this decision. Assuming a

perfect capital market, describe what you can do to undo the effect of this decision.

5

Hardmon Enterprises is currently an all-equity firm with an expected return of

17 %17%.

It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares.

Assume perfect capital markets.

a. Suppose Hardmon borrows to the point that its debt-equity ratio is 0.50. With this amount of debt, the

debt cost of capital is

4 %4%.

What will the expected return of equity be after this transaction?

b. Suppose instead Hardmon borrows to the point that its debt-equity ratio is 1.50. With this amount

of debt, Hardmon's debt will be much riskier. As a result, the debt cost of capital will be

6 %6%.

What will the expected return of equity be in this case?

c. A senior manager argues that it is in the best interest of the shareholders to choose the capital

structure that leads to the highest expected return for the stock. How would you respond to

this argument?

a. Suppose Hardmon borrows to the point that its debt-equity ratio is 0.50. With this amount of debt, the

debt cost of capital is

4 %4%.

What will the expected return of equity be after this transaction?

Global Pistons (GP) has common stock with a market value of $ 380$380 million and debt with a value of

$ 290$290 million. Investors expect a 17 %17% return on the stock and a 5 %5% return on the debt.

Assume perfect capital markets.

a. Suppose GP issues

$ 290$290

million of new stock to buy back the debt. What is the expected return of the stock after this transaction?

b. Suppose instead GP issues

$ 58.58$58.58

million of new debt to repurchase stock.

i. If the risk of the debt does not change, what is the expected return of the stock after this transaction?

ii. If the risk of the debt increases, would the expected return of the stock be higher or lower than when

debt is issued to repurchase stock in part

(i)?

a. Suppose GP issues

$ 290$290

million of new stock to buy back the debt. What is the expected return of the stock after this transaction?

In mid-2015, Qualcomm Inc. had $1515 billion in debt, total equity capitalization of $8787 billion, and an

equity beta of 1.491.49 (as reported on Yahoo! Finance). Included inQualcomm's assets was $2424

billion in cash and risk-free securities. Assume that the risk-free rate of interest is 3.1 %3.1%

and the market risk premium is 4.1 %4.1%.

a. What is Qualcomm's enterprise value?

b. What is the beta of Qualcomm's business assets?

c. What is Qualcomm's WACC?

a. What is Qualcomm's enterprise value?

0.800.80

and an expected return of

12 %12%.

Suppose it issues new risk-free debt with a

3 %3%

yield and repurchase

10 %10%

of its stock. Assume perfect capital markets.

a. What is the beta of Yerba stock after this transaction?

b. What is the expected return of Yerba stock after this transaction?

Suppose that prior to this transaction, Yerba expected earnings per share this coming year of

$ 4.50$4.50,

with a forward P/E ratio (that is, the share price divided by the expected earnings for the coming year) of

1414.

c. What is Yerba's expected earnings per share after this transaction? Does this change benefit

the shareholder? Explain.

d. What is Yerba's forward P/E ratio after this transaction? Is this change in the P/E ratio reasonable?

Explain.

a. What is the beta of Yerba stock after this transaction?

8080

million shares outstanding currently trading for

$ 7.47$7.47

per share. Suppose Zelnor decides to grant a total of

88

million new shares to employees as part of a new compensation plan. The firm argues that this new

compensation plan will motivate employees and is better than giving salary bonuses because it will not

cost the firm anything. Assume perfect capital markets.

a. If the new compensation plan has no effect on the value of Zelnor's assets, what will be the share price

of the stock once this plan is implemented?

b. What is the cost of this plan for Zelnor investors? Why is issuing equity costly in this case?

a. If the new compensation plan has no effect on the value of Zelnor's assets, what will be the share price

of the stock once this plan is implemented?

Schwartz Industry is an industrial company with 87.1 million shares outstanding and a market

capitalization (equity value) of $ 4.79 billion. It has $1.26 billion of debt outstanding. Management have

decided to delever the firm by issuing new equity to repay all outstanding debt.

b. Suppose you are a shareholder holding 100 shares, and you disagree with this decision. Assuming a

perfect capital market, describe what you can do to undo the effect of this decision.

b. Suppose you are a shareholder holding 100 shares, and you disagree with this decision. Assuming a

perfect capital market, describe what you can do to undo the effect of this decision.

You are an entrepreneur starting a biotechnology firm. If your research is successful, the technology can

be sold for $ 22 million. If your research is unsuccessful, it will be worth nothing. To fund your research,

you need to raise $3.4 million. Investors are willing to provide you with $3.4 million in initial capital in

exchange for 50 % of the unlevered equity in the firm.

b. Suppose you borrow $0.7 million. According to MM, what fraction of the firm's equity will you need to

sell to raise the additional $2.7 million you need?

c. What is the value of your share of the firm's equity in cases (a) and (b)?

b. Suppose you borrow $0.7 million. According to MM, what fraction of the firm's equity will you need to

sell to raise the additional $2.7 million you need?

c. What is the value of your share of the firm's equity in cases (a) and (b)?

In mid-2015, Qualcomm Inc. had $12 billion in debt, total equity capitalization of $91 billion, and an

equity beta of 1.35 (as reported on Yahoo! Finance). Included in Qualcomm's assets was $22 billion in

cash and risk-free securities. Assume that the risk-free rate of interest is 3.1 % and the market risk

premium is 4.1 %.

The WACC is

nothing%. (Round to one decimal place.)

Zelnor, Inc., is an all-equity firm with 180 million shares outstanding currently trading for $ 12.67 per

share. Suppose Zelnor decides to grant a total of 18 million new shares to employees as part of a new

compensation plan. The firm argues that this new compensation plan will motivate employees and is

better than giving salary bonuses because it will not cost the firm anything. Assume perfect capital

markets.

a. If the new compensation plan has no effect on the value of Zelnor's assets, what will be the share

price of the stock once this plan is implemented?

b. What is the cost of this plan for Zelnor investors? Why is issuing equity costly in this case?

a. If the new compensation plan has no effect on the value of Zelnor's assets, what will be the share

price of the stock once this plan is implemented?

If the new compensation plan has no effect on the value of Zelnor's assets, the new share price will be $

b. What is the cost of this plan for Zelnor investors? Why is issuing equity costly in this case?

Why is issuing equity costly in this case? (Select the best choice below.)

A.

It's costly because the shareholder equity is being given away to employees for free.

B.

It is not costly because we are not taking into account the benefit of the equity to the employees. Once

that is accounted for, the value of the firm will be the same.

C.

This is a standard example of the effect of dilution on the share price which is always costly.

D.

Global Pistons (GP) has common stock with a market value of $ 490 million and debt with a value of $

273 million. Investors expect a 17 % return on the stock and a 7 % return on the debt. Assume perfect

capital markets.

a. Suppose GP issues $ 273 million of new stock to buy back the debt. What is the expected return of the

stock after this transaction?

i. If the risk of the debt does not change, what is the expected return of the stock after this transaction?

ii. If the risk of the debt increases, would the expected return of the stock be higher or lower than when

debt is issued to repurchase stock in part (i)?

a. Suppose GP issues $ 273 million of new stock to buy back the debt. What is the expected return of the

stock after this transaction?

If GP issues $ 273 million of new stock to buy back the debt, the expected return is

i. If the risk of the debt does not change, what is the expected return of the stock after this transaction?

If GP issues $ 96.92 million of new debt to repurchase stock and the risk of the debt does not change,

the expected return is

ii. If the risk of the debt increases, would the expected return of the stock be higher or lower than when

debt is issued to repurchase stock in part (i)? (Select the best choice below.)

Higher

leveraged recapitalization in which it would borrow and repurchase existing shares. Assume perfect

capital markets.

a. Suppose Hardmon borrows to the point that its debt-equity ratio is 0.50. With this amount of debt,

the debt cost of capital is 5 %. What will the expected return of equity be after this transaction?

b. Suppose instead Hardmon borrows to the point that its debt-equity ratio is 1.50. With this amount of

debt, Hardmon's debt will be much riskier. As a result, the debt cost of capital will be 7 %. What will the

expected return of equity be in this case?

c. A senior manager argues that it is in the best interest of the shareholders to choose the capital

structure that leads to the highest expected return for the stock. How would you respond to this

argument?

a. Suppose Hardmon borrows to the point that its debt-equity ratio is 0.50. With this amount of debt,

the debt cost of capital is 5 %. What will the expected return of equity be after this transaction?

If Hardmon borrows to the point that its debt-equity ratio is 0.50 and the debt cost of capital is 5 %, the

expected return is

b. Suppose instead Hardmon borrows to the point that its debt-equity ratio is 1.50. With this amount of

debt, Hardmon's debt will be much riskier. As a result, the debt cost of capital will be 7 %. What will the

expected return of equity be in this case?

If Hardmon borrows to the point that its debt-equity ratio is 1.50 and the debt cost of capital is 7 %, the

expected return is

c. A senior manager argues that it is in the best interest of the shareholders to choose the capital

structure that leads to the highest expected return for the stock. How would you respond to this

argument?

Yerba Industries is an all-equity firm whose stock has a beta of 0.50 and an expected return of 13 %.

Suppose it issues new risk-free debt with a 5.5 % yield and repurchase 30 % of its stock. Assume perfect

capital markets.

Suppose that prior to this transaction, Yerba expected earnings per share this coming year of $ 4.50, with

a forward P/E ratio (that is, the share price divided by the expected earnings for the coming year) of 9.

c. What is Yerba's expected earnings per share after this transaction? Does this change benefit the

shareholder? Explain.

d. What is Yerba's forward P/E ratio after this transaction? Is this change in the P/E ratio reasonable?

Explain.

Suppose that prior to this transaction, Yerba expected earnings per share this coming year of $ 4.50, with

a forward P/E ratio (that is, the share price divided by the expected earnings for the coming year) of 9.

c. What is Yerba's expected earnings per share after this transaction? Does this change benefit the

shareholder? Explain.

If prior to the transaction, Yerba expected earnings per share this coming year of $ 4.50, with a forward

P/E ratio of 9, Yerba's expected earnings per share after thi

Explain what is wrong with the following argument: "If a firm issues debt that is risk free, because there

is no possibility of default, the risk of the firm's equity does not change. Therefore, risk-free debt allows

the firm to get the benefit of a low cost of capital of debt without raising its cost of capital of equity."

A.

The argument is wrong because any leverage raises the equity cost of capital. Risk-free leverage raises it

the most because it does not share any of the risk.

B.

The argument is wrong because any leverage raises the equity cost of capital. Risk-free leverage raises it

the least because it does not share any of the risk.

C.

The argument is correct because debt has a lower cost of capital than equity and a firm can reduce its

overall weighted average cost of capital by increasing the amount of debt financing.

D.

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