6. Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a Boom and $50 in a Slump. There is a 50% chance of each event. Firm U is entirely equity-financed; therefore, shareholders receive the entire income. Its shares are valued at $500. Firm L has issued $400 of risk-free debt at an interest rate of 10%; therefore, $40 of Firm L's income is paid out as interest. There are no taxes. Investors can borrow and lend at risk free rate. a. What is the value of L's stock? b. Suppose you invest $20 in Firm U's stock. Is there an alternative investment in Firm L that would give the same payoffs in a Boom and a Slump? What is the expected payoff from such a strategy? c. Now suppose that you invest $20 in Firm L's stock. Design an alternative strategy with identical payoffs. d. Now show that MM's proposition II holds. 2 of 2

6. Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a Boom and $50 in a Slump. There is a 50% chance of each event. Firm U is entirely equity-financed; therefore, shareholders receive the entire income. Its shares are valued at $500. Firm L has issued $400 of risk-free debt at an interest rate of 10%; therefore, $40 of Firm L's income is paid out as interest. There are no taxes. Investors can borrow and lend at risk free rate. a. What is the value of L's stock? b. Suppose you invest $20 in Firm U's stock. Is there an alternative investment in Firm L that would give the same payoffs in a Boom and a Slump? What is the expected payoff from such a strategy? c. Now suppose that you invest $20 in Firm L's stock. Design an alternative strategy with identical payoffs. d. Now show that MM's proposition II holds. 2 of 2

Intermediate Financial Management (MindTap Course List)

13th Edition

ISBN:9781337395083

Author:Eugene F. Brigham, Phillip R. Daves

Publisher:Eugene F. Brigham, Phillip R. Daves

Chapter17: Dynamic Capital Structures And Corporate Valuation

Section: Chapter Questions

Problem 7P

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CO A has cash flows of $0.76 per share, earnings of $1.25 per share and 115,000 shares outstanding. Co B. is a comparable public company with a price of $S60 per share, cash flows of $2.14 per share, and 510,000 shares outstanding. If CoBis a sufficiently comparable company, what do you estimate Co B. price per share to be? Assume: Risk free rate 4% Market risk premium 7% Cost of debt 4%, beta of debt is 0. Tax rate 23%
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1)An all-equity firm has 9 million shares outstanding and each share is priced at $167. The firm announces that it will be issuing $260 million in permanent debt that they will use to repurchase shares. The market hears this news and assimilates the information immediately. What is the new share price? Assume the firm's tax rate is 21% and there are no financial distress costs. 2)A CEO, working on behalf of the equityholders, is choosing between two mutually-exclusive projects: A and B. A has a 100% probability of earning $150 million. B has an 80% probability of earning $200 million and a 20% probability of earning $0. Ignore discounting. The firm has debt to pay of $100 million. Solve for which project has the highest expected value for the equityholders. What is that value? 3) Your firm is evaluating a project that will generate the following cash flows next year with the following probabilities: Cash Flow at t=1 Probability Good Case $600M 0.75 Bad Case $200M 0.25 You…
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Q47 The Engineering Company currently has 100,000 outstanding stocks selling at OMR 100 each. The firm is also thinking of declaring a dividend of OMR 5 per share at the end of the current fiscal year. The firms opportunity cost of capital is 10%. What will be price of the stock at the end of the year assume that dividend is declared under MM model? a. OMR 105 b. OMR 115 c. OMR 110 d. OMR 100