FUNDAMENTALS OF CORP.FIN.(LL)-W/CONNECT
FUNDAMENTALS OF CORP.FIN.(LL)-W/CONNECT
10th Edition
ISBN: 9781260848670
Author: BREALEY
Publisher: MCG
Question
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Chapter 16, Problem 11QP

a)

Summary Introduction

To determine: Stock’s beta after refinancing.

a)

Expert Solution
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Explanation of Solution

Given information:

Beta of firm entirely by equity and debt is 1, so beta of equity is 0.5 and beta of debt is 0.5.

The formula used is,

βassets=(βdebt×DV)+(βequity×EV)

Calculation of beta after refinancing:

1=(βdebt×0.5)+(βequity×0.5)1=0+(βequity×0.5)βequity=10.5=2

Hence, value of beta after refinancing is 2.

b)

Summary Introduction

To determine: Required return and risk premium before refinancing.

b)

Expert Solution
Check Mark

Explanation of Solution

Given information:

The return on stock is 10%, and return on assets also be 10%,

The risk free rate of return is 5%,

Calculation of risk premium:

Riskpremium=requityrdebt=10%5%=5%

Hence, return on stock is 10% and risk premium is 5%.

c)

Summary Introduction

To determine: Required return and risk premium after refinancing.

c)

Expert Solution
Check Mark

Explanation of Solution

Given information:

Debt value ratio is 0.5

Calculation of return on equity:

rassets=rassets+(DE×(rassetsrdebt))requity=0.1+(1×(0.10.05))requity=15%

Hence, return on equity is 15%

Calculation of risk premium:

Riskpremium=requityrdebt=15%5%=10%

Hence, risk premium is 10%.

d)

Summary Introduction

To determine: Required return on debt.

d)

Expert Solution
Check Mark

Explanation of Solution

The required return on debt is here, is as same as risk free rate of 5%

e)

Summary Introduction

To determine: Required return on asset after refinancing.

e)

Expert Solution
Check Mark

Explanation of Solution

Given information:

The return on stock is 15%, and return on debt is 5%

Calculation of return on asset:

rassets=(rdebt×DV)+(requity×EV)=(5%×0.5)+(15%×0.5)=10%

Hence, return on asset is 10%

f)

Summary Introduction

To determine: Percentage increase in EPS after refinancing.

f)

Expert Solution
Check Mark

Explanation of Solution

Given information:

Total equity before financing is $10,000

Expected earnings would be $1,000 ($10,000 x 10%)

Calculation of interest:

Interest=Debt×Interestrate=$5,000×5%=$250

Calculation of equity earnings:

Equity earnings=Operatingincome Interest=$1,000$250=$750

Calculation of earnings per share before refinancing:

Earnings per sharebefore refinancing=EquityearningsNumberofsharesoutstanding=$1,0001,000=$1

Calculation of earnings per share after refinancing:

Earnings per shareafter refinancing=EquityearningsNumberofsharesoutstanding=$750500=1.5

Calculation of increase in EPS:

Increase in EPS=(EPSAfterrefinancingEPSbeforerefinancingEPSbeforerefinancing)=(1.511)×100=50%

Hence, increase in EPS is 50%.

g)

Summary Introduction

To determine: New price multiple.

g)

Expert Solution
Check Mark

Explanation of Solution

Calculation of new price multiple:

New price multiple=101.5=6.67

Hence, new price multiple is 6.67

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