PRIN.OF CORPORATE FINANCE
13th Edition
ISBN: 9781260013900
Author: BREALEY
Publisher: RENT MCG
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Chapter 17, Problem 2PS
Homemade leverage 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 is risk-free.
- a. Rosencrantz owns 1% of the common stock of A. What other investment package would produce identical cash flows for Rosencrantz?
- b. Guildenstern owns 2% of the common stock of B. What other investment package would produce identical cash flows for Guildenstern?
- c. Show that neither Rosencrantz nor Guildenstern would invest in the common stock of B if the total value of company A were less than that of B.
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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?
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.
Assume a Modigliani and Miller economy. Company XYZ is currently financed only withequity. The management of the company hires a consultant. The consultant makes thefollowing suggestion: “My advice for XYZ is to issue debt and use it to repurchase some ofthe company’s equity. This would allow XYZ to get the benefit of a low cost of capital ofdebt without raising its cost of capital of equity.”Discuss in detail the statement of the consultant.
Chapter 17 Solutions
PRIN.OF CORPORATE FINANCE
Ch. 17 - Homemade leverage Ms. Kraft owns 50,000 shares of...Ch. 17 - Homemade leverage Companies A and B differ only in...Ch. 17 - Corporate leverage Suppose that Macbeth Spot...Ch. 17 - Corporate leverage Reliable Gearing currently is...Ch. 17 - MMs propositions True or false? a. MMs...Ch. 17 - MMs propositions What is wrong with the following...Ch. 17 - Prob. 7PSCh. 17 - MM proposition 1 Executive Cheese has issued debt...Ch. 17 - Prob. 9PSCh. 17 - Prob. 10PS
Ch. 17 - MM proposition 2 Spam Corp. is financed entirely...Ch. 17 - MM proposition 2. Increasing financial leverage...Ch. 17 - Prob. 13PSCh. 17 - MM proposition 2 Look back to Section 17-1....Ch. 17 - MM proposition 2 Hubbards Pet Foods is financed...Ch. 17 - MM proposition 2 Imagine a firm that is expected...Ch. 17 - MM proposition 2 Archimedes Levers is financed by...Ch. 17 - MM proposition 2 Look back to Problem 17. Suppose...Ch. 17 - Prob. 19PSCh. 17 - After-tax WACC Gaucho Services starts life with...Ch. 17 - After-tax WACC Omega Corporation has 10 million...Ch. 17 - After-tax WACC Gamma Airlines has an asset beta of...Ch. 17 - Prob. 23PSCh. 17 - Investor choice People often convey the idea...Ch. 17 - Investor choice Suppose that new security designs...
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