Loose Leaf for Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
11th Edition
ISBN: 9781259709685
Author: Stephen A. Ross Franco Modigliani Professor of Financial Economics Professor, Randolph W Westerfield Robert R. Dockson Deans Chair in Bus. Admin., Jeffrey Jaffe
Publisher: McGraw-Hill Education
expand_more
expand_more
format_list_bulleted
Textbook Question
Chapter 16, Problem 22QP
Homemade Leverage 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 $l.4 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.
Veblen | Knight | |
Projected operating income | $ 580,000 | $ 580,000 |
Year-end interest on debt | 84,000 | |
Market value of stock | $ 4,500,000 | 3,450 000 |
Market value of debt | 1,400,000 |
- a. 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?
- b. Given the two investment strategies in (a), which will investors choose? When will this process cease?
Expert Solution & Answer
Want to see the full answer?
Check out a sample textbook solutionStudents have asked these similar questions
Homemade Leverage and WACC ABC Company and XYZ Company are identical firms in all respects except for their capital structure. ABC is all-equity financed with $650,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $325,000 and the interest rate on its debt is 6.5 percent. Both firms expect EBIT to be $71,000. Ignore taxes. a. Rico owns $39,000 worth of XYZ's stock. What rate of return is he expecting? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. Suppose Rico invests in ABC Company and uses homemade leverage to match his cash flow in part (a). Calculate his total cash flow and rate of return. (Do not round intermediate calculations and enter your return answer as a percent rounded to 2 decimal places, e.g., 32.16.) c. What is the cost of equity for ABC and xyz? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) d. What is…
In-Class Example : MM Proposition I without Corporate Taxes
Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all-equity firm, has 18,000 shares of stock outstanding, currently worth $35 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta’s debt is $85,000, and its cost of debt is 9 percent. Each firm is expected to have earnings before interest and tax of $93,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 9 percent per year, and no market frictions exist (perfect capital markets).
What is the value of Alpha Corporation?
What is the value of Beta Corporation?
What is the market value of Beta Corporation’s equity?
How much will it cost to purchase 20 percent of each firm’s equity?
Assuming each firm meets its earnings estimates, what will be the dollar return to each position in part (d) over the next year?…
Homemade Leverage [LO1] The Day Company and the KnightCompany are identical in every respect except that Day is notlevered. Financial information for the two firms appears in thefollowing table. All earnings streams are perpetuities, and neitherfirm pays taxes. Both firms distribute all earnings available tocommon stockholders immediately.Day KnightProjected operating income $ 375,000 $ 375,000Year-end interest on debt — $ 54,000Market value of stock $2,300,000 $1,650,000Market value of debt — $ 900,000An investor who can borrow at 6 percent per year wishes topurchase 5 percent of Knight’s equity. Can he increase hisdollar return by purchasing 5 percent of Day’s equity if heborrows so that the initial net costs of the strategies are thesame?Given the two investment strategies in (a), which willinvestors choose? When will this process cease?
Chapter 16 Solutions
Loose Leaf for Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
Ch. 16 - MM Assumptions List the three assumptions that lie...Ch. 16 - Prob. 2CQCh. 16 - Prob. 3CQCh. 16 - MM Propositions What is the quirk in the tax code...Ch. 16 - Prob. 5CQCh. 16 - Prob. 6CQCh. 16 - Optimal Capital Structure Is there an easily...Ch. 16 - Financial Leverage Why is the use of debt...Ch. 16 - Homemade Leverage What is homemade leverage?Ch. 16 - Capital Structure Goal What is the basic goal of...
Ch. 16 - Prob. 1QPCh. 16 - EBIT, Taxes, and Leverage Repeat p arts (a) and...Ch. 16 - ROE and Leverage Suppose the company in Problem 1...Ch. 16 - Break-Even EBIT Franklin Corporation is comparing...Ch. 16 - Prob. 5QPCh. 16 - Break-Even EBIT and Leverage Kolby Corp. is...Ch. 16 - Leverage and Stock Value Ignoring taxes in Problem...Ch. 16 - Homemade Leverage Star, Inc., a prominent consumer...Ch. 16 - Homemade Leverage and WACC ABC Co. and XYZ Co. are...Ch. 16 - MM Scarlett Corp. uses no debt. The weighted...Ch. 16 - Prob. 11QPCh. 16 - Calculating WACC Weston Industries has a...Ch. 16 - Prob. 13QPCh. 16 - MM and Taxes Bruce Co. expects its EBIT to be...Ch. 16 - MM and Taxes In Problem 14, what is the cost of...Ch. 16 - MM Proposition I Levered, Inc., and Unlevered,...Ch. 16 - MM Tool Manufacturing bas an expected EBIT of...Ch. 16 - Firm Value Cavo Corporation expects an EBIT of...Ch. 16 - MM Proposition I with Taxes The Dart Company is...Ch. 16 - MM Proposition I without Taxes Alpha Corporation...Ch. 16 - Cost of Capital Acetate, Inc., has equity with a...Ch. 16 - Homemade Leverage The Veblen Company and the...Ch. 16 - MM Propositions Locomotive Corporation is planning...Ch. 16 - Stock Value and Leverage Green Manufacturing,...Ch. 16 - Prob. 25QPCh. 16 - Prob. 26QPCh. 16 - Prob. 27QPCh. 16 - Prob. 28QPCh. 16 - Prob. 29QPCh. 16 - Prob. 30QPCh. 16 - STEPHENSON REAL ESTATE RECAPITALIZATION Stephenson...Ch. 16 - Prob. 2MCCh. 16 - Prob. 3MCCh. 16 - Prob. 4MCCh. 16 - Prob. 5MC
Knowledge Booster
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.Similar questions
- capital structure 1. Enya Company 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 RM4.3 million worth of debt outstanding. The cost of this debt is 10 percent per year. Enya expects to have an EBIT of RM1.68 million per year in perpetuity. Enya pays no taxes. I. What is the market value of Locomotive Corporation before and after the repurchase announcement? II. What is the expected return on the firm’s equity before the announcement of the stock repurchase plan? III. What is the expected return on the equity of an otherwise identical all-equity firm? IV. What is the expected return on the firm’s equity after the announcement of the stock repurchase plan?arrow_forwardDebt Irrelevance. Companies A and B differ only in their capital structure. A is financed 30%debt and 70% equity; B is financed 10% debt and 90% equity. The debt of both companies isrisk-free. (LO16-1)a. Rosencrantz owns 1% of the common stock of A. What other investment package wouldproduce identical cash flows for Rosencrantz?b. Guildenstern owns 2% of the common stock of B. What other investment package wouldproduce identical cash flows for Guildenstern?arrow_forwardWACC The Patrick Company’s year-end balance sheet is shown below. Its cost of common equity is 16%, its before-tax cost of debt is 13%, and its marginal tax rate is 40%. Assume that the firm’s long-term debt sells at par value. The firm’s total debt, which is the sum of the company’s short-term debt and long-term debt, equals $1,152. The firm has 576 shares of common stock outstanding that sell for $4.00 per share. Calculate Patrick’s WACC usingmarket-value weights. Assets Liabilities and Equity Cash $130 Accounts payable and accruals $10 Accounts receivable 240 Short term debt 52 Inventories 360 Long term debt 1,100 Plant and equipment, net 2,160 Common equity 1,1728 Total assets $2,890 Total liabilities and equity $2,890arrow_forward
- Plz complete using excel showing formula of work !! XYZ Corp is comparing two different capital structures. Under Plan I, the company has no debt and has 100,000 shares of stock outstanding selling at a price of $20 per share. Under Plan II, the company will convert 40,000 shares of stock outstanding to debt at an interest rate of 10%. Assume that there are no taxes. a. If EBIT is $100,000, which plan will result in higher ROE? b. If EBIT is $800,000, which plan will result in higher ROE? c. What can you conclude from the values of ROE obtained in a. and b.? *ROE is calculated as the ratio of Net Income to Equityarrow_forwardFirm LM's debt-to-total-assets ratio (D/TA) is 25 percent, whereas Firm QR's D/TA ratio is 50 percent. LM has $800,000 in assets, $60,000 EBIT, and 15,000 shares of stock outstanding, and it pays 8 percent interest. QR has $400,000 in assets, $70,000 EBIT, and 25,000 shares of stock outstading, and it pays 10 percent interest. The marginal tax rate for both firms is 40 percent. Calculate each firm's EPS and ROE (ROE = Net income/Equity). Discuss your results.arrow_forward
arrow_back_ios
arrow_forward_ios
Recommended textbooks for you
- Intermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage LearningEBK CONTEMPORARY FINANCIAL MANAGEMENTFinanceISBN:9781337514835Author:MOYERPublisher:CENGAGE LEARNING - CONSIGNMENT
- Cornerstones of Financial AccountingAccountingISBN:9781337690881Author:Jay Rich, Jeff JonesPublisher:Cengage Learning
Intermediate Financial Management (MindTap Course...
Finance
ISBN:9781337395083
Author:Eugene F. Brigham, Phillip R. Daves
Publisher:Cengage Learning
EBK CONTEMPORARY FINANCIAL MANAGEMENT
Finance
ISBN:9781337514835
Author:MOYER
Publisher:CENGAGE LEARNING - CONSIGNMENT
Cornerstones of Financial Accounting
Accounting
ISBN:9781337690881
Author:Jay Rich, Jeff Jones
Publisher:Cengage Learning
Financial ratio analysis; Author: The Finance Storyteller;https://www.youtube.com/watch?v=MTq7HuvoGck;License: Standard Youtube License