EBK CONTEMPORARY FINANCIAL MANAGEMENT
14th Edition
ISBN: 9781337514835
Author: MOYER
Publisher: CENGAGE LEARNING - CONSIGNMENT
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Chapter 13, Problem 3P
a)
Summary Introduction
To determine: The market value of no leverage Inc.
b)
Summary Introduction
To determine: The market value of high leverage Inc.
c)
Summary Introduction
To determine: The present value of tax shield of high leverage Inc.
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Assume zero corporate tax rate. Acorn Industries owns assets that have 80% probability
of having market value $50 million in one year and 20% probability of having market
value $20 million in one year. The risk free rate is 4% and Acorn's assets have cost of
capital 10%. (a) If Acorn is unlevered, what is the value of Acorn's equity? (b) What is the
expected return on equity? (c) What is the volatility of the equity return? (d) What is the
WACC?
Two firms, No Leverage Inc. and High Leverage Inc. have equal levels of operating risk and differ only in their capital structure. No Leverage is unlevered and High Leverage has $600,000 of perpetual debt in its capital structure. Assume that the perpetual annual income of both firms available for stockholders is paid out as dividends. Hence, the growth rate for both firms is zero. The income tax rate for both firms is 40 percent. Assume that there are no financial distress costs or agency costs. You are given the following data:
No Leverage, Inc.
High Leverage, Inc.
Equity in capital structure
$
1,400,000
$
800,000
Cost of equity, ke
10
%
11
%
Debt in capital structure
-
$
600,000
Pretax cost of debt, kd
-
8.5
%
Net operating income (EBIT)
$
150,000
$
150,000
Determine the
Market value of No Leverage, Inc. Round your answer to the nearest dollar.$
Market value of High Leverage, Inc. Round your answer to the…
The Gecko Company and the Gordon Company are two firms whose business risk is the same but that
have different dividend policies. Gecko pays no dividend, whereas Gordon has an expected dividend yield
of 7 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 40 percent. Gecko
has an expected earnings growth rate of 16 percent annually, and its stock price is expected to grow at this
same rate. If the aftertax expected returns on the two stocks are equal (because they are in the same risk
class), what is the pretax required return on Gordon's stock?
Note: Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal
places, e.g., 32.16.
Pretax return
%
Chapter 13 Solutions
EBK CONTEMPORARY FINANCIAL MANAGEMENT
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- The Rivoli Company has no debt outstanding, and its financial position is given by the following data: What is Rivoli’s intrinsic value of operations (i.e., its unlevered value)? What is its intrinsic stock price? Its earnings per share? Rivoli is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with 30% debt based on market values, its cost of equity, rs, will increase to 12% to reflect the increased risk. Bonds can be sold at a cost, rd, of 7%. Based on the new capital structure, what is the new weighted average cost of capital? What is the levered value of the firm? What is the amount of debt? Based on the new capital structure, what is the new stock price? What is the remaining number of shares? What is the new earnings per share?arrow_forwardThe Gecko Company and the Gordon Company are two firms whose business risk is the same but that have different dividend policies. Gecko pays no dividend, whereas Gordon has an expected dividend yield of 4 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 25 percent. Gecko has an expected earnings growth rate of 12 percent annually, and its stock price is expected to grow at this same rate. If the aftertax expected returns on the two stocks are equal (because they are in the same risk class), what is the pretax required return on Gordon’s stock? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)arrow_forwardPlease show your work for the following Suppose that your firm's current unlevered value, V*, is $800,000, and its marginal corporate tax rate is 21 percent. Also, you model the firm's PV of financial distress as a function of its debt level according to the relation: PV of financial distress = 800,000 × (D/V*)2. What is the firm's levered value if it issues $200,000 of perpetual debt to buy back stock? Multiple Choice A) $920,000. B) $869,555. C) $792,000. D) $350,000.arrow_forward
- To illustrate the effects of financial leverage for PizzaPalace’s management, consider two hypothetical firms: Firm U (which uses no debt financing) and Firm L (which uses $4,000 of 8% interest rate debt). Both firms have $20,000 in net operating capital, a 25% tax rate, and an expected EBIT of $2,400. (1) Construct partial income statements, which start with EBIT, for the two firms. (2) Calculate NOPAT, ROIC, and ROE for both firms. (3) What does this example illustrate about the impact of financial leverage on ROE? (4) Why did leverage increase ROE in this example?arrow_forwardIn a world with corporate taxes but no possibility of financial distress, the value of the firm is maximized when the: Firm uses the maximum amount of debt in its capital structure. Firm uses a debt-equity ratio of 1.0. Firm uses no debt in its capital structure. Corporate tax rate approaches 100%.arrow_forwardTaking the corporate taxes into account, if there is no possibility of financial distress, a firm can maximize its market value when the: firm uses a debt-equity ratio of 1.0. firm uses the maximum amount of debt in its capital structure. firm uses no debt in its capital structure. corporate tax rate approaches 100%.arrow_forward
- An unlevered firm has a value of $500 million. An otherwise identical butlevered firm has $50 million in debt. Under the MM zero-tax model, whatis the value of the levered firm?arrow_forwardSuppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $1,000 on which it pays interest of 12% each year. Both companies have identical projects that generate free cash flows of $900 or $1,400 each year. After paying any interest on debt, both companies use all remaining free cash flows to pay dividends each year. a. In the table below, fill in the debt payments and equity dividends each firm will receive given each of the two possible levels of free cash flows. b. Suppose you hold 10% of the equity of ABC. What is another portfolio you could hold that would provide the same cash flows? c. Suppose you hold 10% of the equity of XYZ. If you can borrow at 12%, what is an alternative strategy that would provide the same cash flows? a. In the table below, fill in the payments debt and equity holders of each firm will receive given each of the two possible levels of free cash flows. (Round to the nearest dollar.) АВС XYZ FCF Debt Payments Equity Dividends Debt Payments…arrow_forward(c) Consider the case of two firms, ABC which is an unlevered firm and XYZ which is a levered firm. The firms have target debt-to-equity ratio (B/S) = 1, and both firms have exactly the same perpetual net operating income of Kshs.12 million before taxes. The before-tax cost of debt, kp, is the same as the risk-free rate and the corporate tax rate is 30%. Given the following market parameters: E(Rm) = 0.12, Rf = 6%. Вавс — 1, Bxyz = 1.5 (i). Find the cost of capital of each firm. (ii). Find the value of each firm.arrow_forward
- Consider two firms that are identical in every respect EXCEPT for their capital structures. The unlevered firm is financed entirely by equity whereas the capital structure of the levered firm includes $30,000 of debt at 12%.The annual earnings of both companies before interest are the same, $10,000. The cost of equity in the unlevered firm is 15% and in the levered company at 16%. A) Determine the market values of the two companies. B) Suppose an investor owns 1% of the equity in the levered firm, describe the arbitrage process.arrow_forwardGive only typing answer with explanation and conclusion U and L are two firms with the same EBIT of $115,000. They are identical in every respect except firm L has a debt of $900,000 at 6% rate of interest. The cost of equity of firm U is 8% and that of firm L is 10%. Assume that arbitrage principle will be applied in this setting and it is possible to make an arbitrage profit (surplus). Also, all earnings streams are perpetuities, taxes are ignored and both firms distribute?arrow_forwardAssume that Firms U and L are in the same risk class and that both have EBIT=$500,000. Firm U uses no debt financing, and its cost of equity is rsU=14%. Firm L has $1 million of debt outstanding at a cost of rd=8%. There are no taxes. Assume that the MM assumptions hold. Graph (a) the relationships between capital costs and leverage as measured by D/V and (b) the relationship between V and D. Now assume that Firms L and U are both subject to a 40% corporate tax rate. Using the data given in Part b, repeat the analysis called for in b(1) and b(2) using assumptions from the MM model with taxes.arrow_forward
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