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GRA6514 - Final Exam - STUDENT
GRA6514 - Final Exam - STUDENT
a) The value of the firm depends on the level of the tax rate.
Question M2 [5 Points]
When should you use the following expression to compute the expected return on levered equity in
a MM world?
D
r E= r U + (r − r )
E U D
a) When there is no taxation only
b) When there is corporate taxation and with a constant level of debt only
c) When there is corporate taxation and with a constant debt-to-equity ratio only
Question M3 [5 Points]
Which of the following statements is False?
a) To determine the benefit of leverage for the value of the firm, we can compute the
present value of the stream of future interest tax shields the firm will receive.
b) Because the cash flows of the levered firm are equal to the sum of the cash flows
from the unlevered firm plus the interest tax shield, by the Law of One Price the
same must be true for the present values of these cash flows.
c) By increasing the amount paid to debt holders through interest payments, the amount
of the pre-tax cash flows that must be paid as taxes increases.*
d) When a firm uses debt, the interest tax shield provides a corporate tax benefit each
year.
Question M4 [5 Points]
Assume that you are in a Modigliani Miller world with perfect capital markets and no taxation. You
have two companies that have the same assets but one is levered and has an asset value equal to VL,
while the other is unlevered and has an asset value equal to VU. If VL>VU, which of the following will
return an arbitrage profit?
a) Short-sell the equity of the unlevered firm and buy the equity and debt of the levered firm
b) Short-sell the equity and the debt of the levered firm and buy the equity of the unlevered firm*
c) Short-sell the equity of the unlevered firm and the debt of the levered firm and buy the equity
of the levered firm
Answer
We know from MM I with tax an perpetual debt that
VL=E+D=VU+Dt=(E+D-Dt) +Dt
The returns offered are
E*rE+D*rD=(E+D-Dt)ru+DtrD
Rearranging the above
rE=ru+(D/E)(rU-rD)(1-t)
Question S2 [8 Points]
Company A’s equity value today is EUR 2,550,000 and in one year it can be worth EUR
2,440,000 with probability 0.5 or EUR 3,876,000 with probability 0.5. The company will
not distribute any dividend. Also the company’s expected return of debt is 2.50% and its
debt-to-equity ratio is 2. Assuming a Modigliani Miller world without taxation or frictions,
what is the unlevered return of equity of Company A?
Answer
ru=9.61%.
For what values of D will the new investment be undertaken in both State 1 and State 2?
Answer
So overall D<=20.
Your company’s debt is rated CCC and at the moment you do not see any possibility of a
recession. The loss given default in an average period (non-recession) is 40%. The entire
amount of your debt is a zero coupon bond with face value 10,000,000, a residual life of one
year and a price that is 90% of the face value. If the risk free rate is 3.50% and the expected
market return is 9.50%.
a) What is the beta of your debt? [9 Points]
b) If there is a 5% chance that we will be in a recession next year and a 95% chance that we
will be in an average economy, how would your answer change? (assume everything else
stays equal) [9 Points]
Answer
a) The beta of debt is 0.455.
b) The beta in this case would be 0.336
b) Assuming that there are 1,000,000 shares outstanding what is the share price? [8
Points]
c) The company unexpectedly announces that it will pay back USD 10,000,000 of debt
and then keep constant perpetually thereafter. What is the new share price after the
company announces this transaction (assuming that it will be carried out soon after)?
[10 Points]
Answer
a) VU=32,005,786.27.
b) P=15.81