PROBLEM SET 4

1. Consider Macbeth Spot Removers, a publically traded company with an infinite life span, which faces a range of annual operating incomes as depicted in the table below. The rate of return on Treasury bonds is 10%.

 Data Number of shares 700 Price per share \$12 Market value of equity \$8400 Outcomes Operating income \$500 \$1,000 \$1,500 \$2,000 Earnings per share \$0.71 \$1.43 \$2.14 \$2.86 Return on equity 5.95% 11.90% 17.86% 23.81%

a. Calculate the earnings per share and return on equity in the table above. Macbeth Spot Removers issues \$2,400 of risk-free debt and uses the proceeds to repurchase 200 shares.

b. Rework the table above to show how earning per share and equity returns now vary with operating income.

c. If the beta of Macbeth s unlevered assets is 0.8 and its debt is risk-free, what would be the beta of the equity after the debt issue?

Ms. Macbeth s investment bankers have just informed her that the new issue of debt is risky. Debtholders will demand a return of 12.5%, which is 2.5% above the risk-free interest rate.

d. How does this affect return on assets and return on equity? Calculate these values.

e. Suppose that the of unlevered equity was 0.6. What will A, E, and D be after the change to the capital structure?

2. Happy Valet, Inc. has a 14.5% cost of unlevered equity and can issue debt at a rate of 8%. It faces marginal corporate income tax rate of 40% and has debt and equity assets of 30% and 70%, respectively (calculated using market values).

a. What rate of return do stockholders require on Happy Valet s levered equity assets?

b. What is the firm s WACC?

3. Consider the case of Henrietta Ketchup, a budding entrepreneur with two possible investment projects that offer the following payoffs:

 Investment Payoff Probability of Payoff Project 1 20.4 25.5 1.0 Project 2 20.4 40.8 0.6 0 0.4

Ms. Ketchup approaches her bank and asks to borrow the present value of \$10 (she will fund the rest out of internal funds).

a. Calculate the expected payoffs to the bank and to Ms. Ketchup if the bank lends the present value of \$10. Which project would Ms. Ketchup undertake?

b. Is this the same project that the bank would want Ms. Ketchup to undertake? Explain why or why not.

c. What is the maximum amount the bank could lend that would induce Ms. Ketchup to take the bank s preferred project?

d. If the bank was to lend the \$10, but was acting strategically in its own interest, what interest rate would the bank require on its loan?

4. You have the following information about Ledd a publicly traded (and therefore infinitely lived) company:

Operating income: \$20 million

Cost of unlevered equity: 10%

Risk-free interest rate: 5%

Corporate marginal tax rate: 0

a. If Ledd is financed entirely by equity,

i. What is the value of the firm?

ii. What is the return required by stockholders?

iii. What is the company s WACC?

b. Ledd decides to issue bonds with the market value of 40% of total assets, using the proceeds to repurchase equity. The bonds are considered to be risk-free.

i. What is the value of Ledd with the new capital structure?

ii. What is the return required by stockholders of the leveraged firm?

iii. What is the WACC?

iv. What is the tax shield of debt?

c. The government implements a marginal corporate tax rate of 36%.

i. Recalculate your answers to a) and b) in a world with taxes.