Chapter 16: 

7, 8, 9, 12, 16, 19, 20, 22, 23, 24

Chapter 17:  1, 4, 5, 6, 7

8. Star, Inc., a prominent consumer products firm, is debating

whether or not to convert its all-equity capital structure to
one that is 40 percent debt. Currently there are 5,000 shares
outstanding and the price per share is $65. EBIT is expected
to remain at $37,500 per year forever. The interest rate on
new debt is 8 percent, and there are no taxes.

1. Ms. Brown, a shareholder of the firm, owns 100 shares of

stock. What is her cash flow under the current capital structure,
assuming the firm has a dividend payout rate of 100 percent?

No tax, so NI = 37,500, EPS = 37,500/5,000 shares = 7.50

Cash flow of Brown who holds 100 shares = 100 x 7.50 = 750
2. What will Ms. Brown’s cash flow be under the proposed
capital structure of the firm? Assume that she keeps all 100 of
her shares.

Under the proposed capital structure. The market value of

the firm is: V = 65(5,000) = 325,000 and new debt amount =
D = 0.40(325,000) = 130,000

Therefore, the number of shares repurchased will be:

Shares repurchased =130,000/65 = 2,000

NI after interest payment = 37,500 – .08(130,000) = 27,100

Therefore EPS = 27,100 / 3,000 shares = 9.03

Since all earnings are paid as dividends, the shareholder will

receive: Shareholder cash flow=9.03(100 shares) = 903.33
 3. Suppose Star does convert, but Ms. Brown prefers the current
all-equity capital structure. Show how she could unlever her
shares of stock to recreate the original capital structure.

To replicate the proposed capital structure, the shareholder

should sell 40 percent of their shares, or 40 shares, and lend
the proceeds at 8 percent. The shareholder will have an
interest income = 40(65)(.08) = 208.00
The shareholder will receive dividend payments on the
remaining 60 shares, so the dividends received will be:
Dividends received = 9.03(60 shares) = 542.00
The total cash flow for the shareholder under these
assumptions will be: Total cash flow = 208 + 542 = 750
4. Using your answer to part (3), explain why Star’s choice of
capital structure is irrelevant.

The capital structure is irrelevant because shareholders can

create their own leverage or unlever the stock to create the
payoff they desire, regardless of the capital structure the firm
actually chooses.

9. ABC Co. and XYZ Co. are identical firms in all respects except
for their capital structure. ABC is all equity financed with
$800,000 in stock. XYZ uses both stock and perpetual debt; its
stock is worth $400,000 and the interest rate on its debt is 10
percent. Both firms expect EBIT to be $95,000. Ignore taxes.

1. Richard owns 30,000 worth of XYZ’s stock. What rate of

return is he expecting?
The rate of return earned will be the dividend yield. The
company has debt, so it must make an interest payment. The
net income for the company is:
NI = 95,000 – .10(400,000) NI = 55,000
 The investor will receive dividends in proportion to the
percentage of the company‘s shares they own. The total
dividends received by Richard will be:
Dividends received = 55,000(30,000/400,000) = 4,125
So the return the shareholder expects is: R = 4,125/30,000
= .1375 or 13.75%

2. Show how Richard could generate exactly the same cash

flows and rate of return by investing in ABC and using
homemade leverage.
To generate exactly the same cash flows in the other
company, the shareholder needs to match the capital
structure of ABC. The shareholder should sell all shares in
XYZ. This will net 30,000. The shareholder should then
borrow 30,000. This will create an interest payment of:
Interest payment = .10(30,000) = 3,000

The investor should then use the proceeds of the stock sale
and the loan to buy shares in ABC. The investor will receive
dividends in proportion to the percentage of the company‘s
share they own. The total dividends received by the
shareholder will be:
Dividends received = 95,000(60,000/800,000) = 7,125

The total cash flow for the shareholder = 7,300 – 3,000 =

4,125
The shareholders return in this case will be: R =
4,125/30,000= .1375 or 13.75%

3. What is the cost of equity for ABC? What is it for XYZ?

ABC is an all equity company, so:

RE = RA = 95,000/800,000 = .1188 or 11.88%
 To find the cost of equity for XYZ, we need to use M&M
Proposition II, so:
RE = RA + (RA – RD)(D/E)(1 – TC)
RE = .1188 + (.1188 – .10)(1)(1) = .1375 or 13.75%

4. What is the WACC for ABC? For XYZ? What principle have
you illustrated?
To find the WACC for each company, we need to use the
WACC equation:
WACC = (E/V)RE + (D/V)RD(1 – TC)
So, for ABC, the WACC is:
WACC = (1)(.1188) + (0)(.10) WACC = .1188 or 11.88%
And for XYZ, the WACC is:
WACC = (1/2)(.1375) + (1/2)(.10) WACC = .1188 or
11.88%

When there are no corporate taxes, the cost of capital for

the firm is unaffected by the capital structure; this is M&M
Proposition I without taxes.

12. Weston Industries has a debt–equity ratio of 1.5. Its

WACC is 12 percent, and its cost of debt is 9 percent. The
corporate tax rate is 35 percent.

1. What is Weston’s cost of equity capital? 21.23%

2. What is Weston’s unlevered cost of equity capital? 15.19%
3. What would the cost of equity be if the debt–equity ratio were
2? What if it were 1.0? What if it were zero? 23.24% 19.21%
15.19%
16. Levered, Inc., and Unlevered, Inc., are identical in every way
except their capital structures. Each company expects to earn
$65 million before interest per year in perpetuity, with each
company distributing all its earnings as dividends. Levered’s
perpetual debt has a market value of $185 million and costs 8
percent per year. Levered has 3.4 million shares outstanding,
currently worth $100 per share. Unlevered has no debt and 7
million shares outstanding, currently worth $80 per share.
Neither firm pays taxes. Is Levered’s stock a better buy than
Unlevered’s stock?

No tax, so Vu = 7,000,000(80) = 560,000,000 = VL

EL = 3,400,000(100) = 340,000,000

The market value of Levered‘s debt is 185 million. The

value of a levered firm equals the market value of its debt
plus the market value of its equity.
Therefore, the current market value of Levered is:
VL = B + S = 185,000,000 + 340,000,000 = 525,000,000

The market value of Levered‘s equity needs to be 375

million, 35 million higher than its current market value of
340 million, for MM Proposition I to hold.

Since Levered‘s market value is less than Unlevered‘s market

value, Levered is relatively underpriced and an investor
should buy shares of the Levered firm‘s stock.
19. The Maxwell Company is financed entirely with equity. The
company is considering a loan of $1.4 million. The loan will
be repaid in equal principal payments installments over the
next two years, and it has an 8 percent interest rate. The
company’s tax rate is 35 percent. According to MM
Proposition I with taxes, what would be the increase in the
value of the company after the loan?

20. Alpha Corporation and Beta Corporation are identical in

every way except their capital structures. Alpha Corporation,
an all-equity firm, has 10,000 shares of stock outstanding,
currently worth $20 per share. Beta Corporation uses
leverage in its capital structure. The market value of Beta’s
debt is $50,000, and its cost of debt is 12 percent. Each firm
is expected to have earnings before interest of $55,000 in
perpetuity. Neither firm pays taxes. Assume that every
investor can borrow at 12 percent per year.

1. What is the value of Alpha Corporation?

2. What is the value of Beta Corporation?
3. What is the market value of Beta Corporation’s equity?

4. How much will it cost to purchase 20 percent of each firm’s

equity?
5. Assuming each firm meets its earnings estimates, what will
be the dollar return to each position in (4) over the next year?
6. Construct an investment strategy in which an investor
purchases 20 percent of Alpha’s equity and replicates both the
cost and dollar return of purchasing 20 percent of Beta’s equity.
The initial cost of purchasing 20 percent of Alpha
Corporation‘s equity is 40,000, but the cost to an investor of
purchasing 20 percent of Beta Corporation‘s equity is only
30,000. In order to purchase 40,000 worth of Alpha‘s equity
using only 30,000 of his own money, the investor must
 borrow 10,000 to cover the difference. The investor will
receive the same dollar return from the Alpha investment,
but will pay interest on the amount borrowed, so the net
dollar return to the investment is:
Net dollar return = $11,000 – .12($10,000) = $9,800
This amount exactly matches the dollar return to an
investor who purchases 20 percent of Beta‘s equity.

7. Is Alpha’s equity more or less risky than Beta’s equity?

Explain.

22. The Veblen Company and the Knight Company are identical
in every respect except that Veblen is not levered. The
market value of Knight Company’s 6 percent bonds is $1.2
million. Financial information for the two firms appears here.
All earnings streams are perpetuities. Neither firm pays taxes.
Both firms distribute all earnings available to common
stockholders immediately.
1. An investor who can borrow at 6 percent per year wishes
to purchase 5 percent of Knight’s equity. Can he increase his
dollar return by purchasing 5 percent of Veblen’s equity if he
borrows so that the initial net costs of the two strategies are
the same?
To purchase 5 percent of Knight‘s equity, the investor
would need = .05($2,532,000) = $126,600
And to purchase 5 percent of Veblen without borrowing
would require: = .05($3,600,000) = $180,000
In order to compare dollar returns, the initial net cost of
both positions should be the same. Therefore, the investor
will need to borrow the difference between the two
amounts, i.e. Amount to borrow = $180,000 – 126,600 =
$53,400

An investor who owns 5 percent of Knight‘s equity will be

entitled to 5 percent of the firm‘s earnings available to
 common stock holders at the end of each year. While
Knight‘s expected operating income is 400,000, it must
pay 72,000 to debt holders before distributing any of its
earnings to stockholders. So, the amount available to this
shareholder will be:
Cash flow from Knight to shareholder = .05(400,000 –
72,000) = 16,400
Veblen will distribute all of its earnings to shareholders,
so the shareholder will receive:
Cash flow from Veblen to shareholder = .05(400,000) =
20,000
However, to have the same initial cost, the investor has
borrowed 53,400 to invest in Veblen, so interest must be
paid on the borrowings. The net cash flow from the
investment in Veblen will be:
Net cash flow from Veblen investment = 20,000 –
.06(53,400) = 16,796
For the same initial cost, the investment in Veblen
produces a higher dollar return.

2. Given the two investment strategies in (1), which will

investors choose? When will this process cease?

23. Locomotive Corporation is planning to repurchase part of its

common stock by issuing corporate debt. As a result, the
firm’s debt–equity ratio is expected to rise from 40 percent to
50 percent. The firm currently has $4.3 million worth of debt
outstanding. The cost of this debt is 10 percent per year.
Locomotive expects to have an EBIT of $1.68 million per
year in perpetuity. Locomotive pays no taxes.
1. What is the market value of Locomotive Corporation
before and after the repurchase announcement?
Before the announcement of the stock repurchase plan,
the market value of the outstanding debt is 4,300,000.
 Using the debt-equity ratio, we can find that the value of
the outstanding equity must be:
Debt-equity ratio=0.40=4,300,000/S or S = 10,750,000
The value of a levered firm is equal to the sum of the
market value of the firm‘s debt and the market value of
the firm‘s equity, so: VL = 4,300,000 + 10,750,000 =
15,050,000
According to MM Proposition I without taxes, changes in
a firm‘s capital structure have no effect on the overall
value of the firm. Therefore, the value of the firm will not
change after the announcement of the stock repurchase
plan
2. What is the expected return on the firm’s equity before the
announcement of the stock repurchase plan?
Before the restructuring, the company was expected to
pay interest in the amount = .10($4,300,000) = $430,000
The return on equity, which is equal to RS, will be:
ROE = RS = ($1,680,000 – 430,000) / $10,750,000 =.1163
or 11.63%

3. What is the expected return on the equity of an otherwise

identical all-equity firm?
According to Modigliani-Miller Proposition II with no
taxes:
RS = R0 + (B/S)(R0 – RB) .1163 = R0 + (.40)(R0 – .10)
R0 = .1116 or 11.16%
OR
R0 = $1,680,000 / $15,050,000 R0 = .1116 or 11.16%
4. What is the expected return on the firm’s equity after the
announcement of the stock repurchase plan?
The cost of equity under the stock repurchase plan will
be:
RS = R0 + (B/S)( R0 – RB) RS = .1116 + (.50)(.1116 – .10) =
.1174 or 11.74%
24. Green Manufacturing, Inc., plans to announce that it will
issue $3 million of perpetual debt and use the proceeds to
repurchase common stock. The bonds will sell at par with a 6
percent annual coupon rate. Green is currently an all-equity
firm worth $9.5 million with 600,000 shares of common
stock outstanding. After the sale of the bonds, Green will
maintain the new capital structure indefinitely. Green
currently generates annual pretax earnings of $1.8 million.
This level of earnings is expected to remain constant in
perpetuity. Green is subject to a corporate tax rate of 40
percent.
1. What is the expected return on Green’s equity before the
announcement of the debt issue? 11.37%

2. Construct Green’s market value balance sheet before the

announcement of the debt issue. What is the price per share
of the firm’s equity? Price per share = $9,500,000 / 600,000 = $15.83

3. Construct Green’s market value balance sheet immediately

after the announcement of the debt issue. Total assets
$10,700,000

4. What is Green’s stock price per share immediately after

the repurchase announcement? New share price = $10,700,000 /
600,000 = $17.83

5. How many shares will Green repurchase as a result of the

debt issue? How many shares of common stock will remain
after the repurchase? New shares outstanding = 431,775.70

6. Construct the market value balance sheet after the

restructuring. Market value of equity = $17.83(431,775.70) = $7,700,000

7. What is the required return on Green’s equity after the

restructuring? 12.62%
Chap. 17
1. Janetta Corp. has an EBIT rate of $850,000 per year that is
expected to continue in perpetuity. The unlevered cost of equity
for the company is 14 percent, and the corporate tax rate is 35
percent. The company also has a perpetual bond issue
outstanding with a market value of $1.9 million.
1. What is the value of the company?
2. The CFO of the company informs the company president that
the value of the company is $4.3 million. Is the CFO correct?

4. Dream, Inc., has debt outstanding with a face value of $5

million. The value of the firm if it were entirely financed by
equity would be $14.5 million. The company also has 300,000
shares of stock outstanding that sell at a price of $35 per share.
The corporate tax rate is 35 percent. What is the decrease in the
value of the company due to expected bankruptcy costs?
VN = $750,000
5. Suppose the president of the company in the previous problem
stated that the company should increase the amount of debt in
its capital structure because of the tax-advantaged status of its
interest payments. His argument is that this action would
increase the value of the company. How would you respond?
The president may be correct, but he may also be incorrect.
6. Steinberg Corporation and Dietrich Corporation are identical
firms except that Dietrich is more levered. Both companies will
remain in business for one more year. The companies’
economists agree that the probability of the continuation of the
current expansion is 80 percent for the next year, and the
probability of a recession is 20 percent. If the expansion
continues, each firm will generate earnings before interest and
taxes (EBIT) of $2.4 million. If a recession occurs, each firm
will generate earnings before interest and taxes (EBIT) of
$900,000. Steinberg’s debt obligation requires the firm to pay
$800,000 at the end of the year. Dietrich’s debt obligation
requires the firm to pay $1.1 million at the end of the year.
Neither firm pays taxes. Assume a discount rate of 15 percent.
1. What is the value today of Steinberg’s debt and equity? What
about that for Dietrich’s?

Expansion EBIT = 2.4m

Steinberg owes its bondholders 800,000 at the end of the year,
its stockholders will receive 1.6 million (= 2,400,000 – 800,000)
If there is a recession, its stockholders will only receive
100,000 (= 900,000 – 800,000). So, assuming a discount rate of
15 percent, the market value of Steinberg‘s equity is:
SSteinberg=[0.80(1,600,000)+0.20(100,000)]/1.15 = 1,130,435

Steinberg‘s bondholders will receive 800,000 whether there is a

recession or a continuation of the expansion. So, the market
value of Steinberg‘s debt is:
B Steinberg=[0.80(800,000)+0.20(800,000)]/1.15 = 695,652

Since Dietrich owes its bondholders 1.1 million at the end of the
year, its stockholders will receive 1.3 million (= 2.4 million –
1.1 million) if the expansion continues. If there is a recession,
its stockholders will receive nothing since the firm‘s
bondholders have a more senior claim on all 800,000 of the
firm‘s earnings. So, the market value of Dietrich‘s equity is:
 S Dietrich = [.80(1,300,000) + .20(0)] / 1.15 = 904,348
Dietrich‘s bondholders will receive 1.1 million if the expansion
continues and 900,000 if there is a recession. So, the market
value of Dietrich‘s debt is:
B Dietrich = [.80(1,100,000) + .20(900,000)] / 1.15 = 921,739

2. Steinberg’s CEO recently stated that Steinberg’s value should

be higher than Dietrich’s because the firm has less debt and
therefore less bankruptcy risk. Do you agree or disagree with
this statement?
Disagree with the CEO‘s statement. The risk of bankruptcy
does not affect a firm‘s value. It is the actual costs of
bankruptcy that decrease the value of a firm. This problem
assumes that there are no bankruptcy costs.

7. Fountain Corporation’s economists estimate that a good

business environment and a bad business environment are
equally likely for the coming year. The managers of Fountain
must choose between two mutually exclusive projects. Assume
that the project Fountain chooses will be the firm’s only activity
and that the firm will close one year from today. Fountain is
obligated to make a $2,500 payment to bondholders at the end
of the year. The projects have the same systematic risk but
different volatilities. Consider the following information
pertaining to the two projects:
1. What is the expected value of the firm if the low-volatility
project is undertaken? What if the high-volatility project is
undertaken? Which of the two strategies maximizes the
expected value of the firm?
Low-volatility project value=0.50(2,500)+0.50($2,700)= 2,600
High-volatility project value=0.50(2,100)+0.50(2,800)=2,450
The low-volatility project maximizes the expected value of
the firm.
2. What is the expected value of the firm’s equity if the low-
volatility project is undertaken? What is it if the high-volatility
project is undertaken?
The value of the equity is the residual value of the company
after the bondholders are paid off. If the low-volatility
project is undertaken, the firm‘s equity will be worth $0 if
the economy is bad and 200 if the economy is good. Since
each of these two scenarios is equally probable, the expected
value of the firm‘s equity is:
Expected value of equity with low-volatility project=0.50(0)+
0.50(200) = 100
And the value of the company if the high-volatility project is
undertaken=0.50(0)+0.50(300) = 150

3. Which project would Fountain’s stockholders prefer?

Risk-neutral investors prefer the strategy with the highest
expected value. Thus, the company‘s stockholders prefer the
high-volatility project since it maximizes the expected value
of the company‘s equity.
4. Suppose bondholders are fully aware that stockholders might
choose to maximize equity value rather than total firm value and
opt for the high-volatility project. To minimize this agency cost,
the firm’s bondholders decide to use a bond covenant to
stipulate that the bondholders can demand a higher payment if
Fountain chooses to take on the high-volatility project. What
payment to bondholders would make stockholders indifferent
between the two projects?
In order to make stockholders indifferent between the low-
volatility project and the high volatility project, the
bondholders will need to raise their required debt payment
so that the expected value of equity if the high-volatility
project is undertaken is equal to the expected value of equity
if the low-volatility project is undertaken. As shown in 1.
above the expected value of equity if the low-volatility
project is undertaken is 2,600. If the high-volatility project is
undertaken, the value of the firm will be 2,100 if the
economy is bad and 2,800 if the economy is good. If the
economy is bad, the entire 2,100 will go to the bondholders
and stockholders will receive nothing. If the economy is
good, stockholders will receive the difference between 2,800,
the total value of the firm, and the required debt payment.
Let X be the debt payment that bondholders will require if
the high-volatility project is undertaken. In order for
stockholders to be indifferent between the two projects, the
expected value of equity if the high-volatility project is
undertaken must be equal to 2,100, so:
Expected value of equity = 100 = 0.50($0) + 0.50(2,800 – X)
X = 2,600