If your research is successful, the technology can be sold for $30 million. If your research is unsuccessful, it will be worth nothing. To fund your research, you need to raise $2 lion. Investors are willing to provide you with $2 million in initial capital in exchange for 50% of the unleavened equity in the firm. A. What is the total market value of the firm without leverage? B. Suppose you borrow $1 million. According to MM, what fraction of the firm’s equity will you need to sell to raise the additional $1 million you need? Value of equity = 2 x $mm = $mm b.
MM says total value of firm is still $4 million. $1 million of debt implies total value of equity is $3 million. Therefore, 33% of equity must be sold to raise $1 million. C. In (a), 50% x $mm = $mm. In (b), 2/3 x $mm = $mm. Thus, in a perfect market the choice of capital structure does not affect the value to the entrepreneur. 14-14. Global Pistons (GAP) has common stock with a market value of $200 million and debt with a value of $100 million. Investors expect a 15% return on the stock and a 6% return on the debt. Assume perfect capital markets. A.
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Suppose GAP issues $100 million of new stock to buy back the debt. What is the expected return of the stock after this transaction? B. Suppose instead GAP issues $50 million of new debt to repurchase stock. I. If the risk of the debt does not change, what is the expected return of the stock after this transaction? It. If the risk of the debt increases, would the expected return of the stock be higher or lower than in part (I)? . If rd is higher, re is lower. The debt will share some of the risk. 14-19. Indeed stock has a current market value of $120 million and a beta of 1. 50.
Indeed currently has risk-free debt as well. The firm decides to change its capital structure by issuing $30 million in additional risk-free debt, and then using this $30 million plus another $10 million in cash to repurchase stock. With perfect capital markets, what will be the beta of Indeed stock after this transaction? Indeed increases its net debt by $40 million ($30 million in new debt + $10 million in cash paid out). Therefore, the value of its equity decreases to 120 – 40 = $80 million. If the debt is risk-free: , where D is the net debt, and EVE is the enterprise value.
The only change in the equation is the value of equity. Therefore fund an expansion by issuing either new shares or new debt. With the expansion, you expect earnings next year of $24 million. The firm currently has 10 million shares outstanding, with a price of $90 per share. Assume perfect capital markets. A. If you raise the $180 million by selling new shares, what will the forecast for next year’s earnings per share be? B. If you raise the $180 million by issuing new debt with an interest rate of 5%, what will the forecast for next year’s earnings per share be? . What is the firm’s forward PIE ratio (that is, the share price divided by the expected earnings for the coming year) if it issues equity? What is the firm’s forward PIE ratio if it issues debt? How can you explain the difference? A. Issue million new shares 12 million shares outstanding. New PEPS= per share. B. Interest on new debt = 180 x 5% = $9 million. The interest expense will reduce earnings to 24-9=$ 15 million. With 10 million shares outstanding, PEPS = per share. C. By MM, share price is $90 in either case.
PEE ratio with equity issue is PEE ratio with debt is = $60. The higher PEE ratio is Justified because with leverage, PEPS will grow at a faster rate. Chapter 15 (2nd Edition) Questions are: 1, 4, 6, 18, 24 15-1. Palmed Pharmaceuticals has BIT of $325 million in 2006. In addition, Palmed has interest expenses of $125 million and a corporate tax rate of 40%. B. What is the total of Pelmet’s 2006 net income and interest payments? C. If Palmed had no interest expenses, what would its 2006 net income be? How does it compare to your answer in part (b)? D.
What is the amount of Pelmet’s interest tax shield in 2006? A. Net Income = BIT – Interest – Taxes = (325 -125)x (1 – 0. 40) = $120 million. B. Net income + Interest = 120+ 125 = $245 million c. Net income = BIT – Taxes = 325 x (1-0. 40) = $195 million. This 245 – 195= $ million lower than part (b) d. Interest tax shield = 125* 40% = $50 million 15-4. Brannon Enterprises currently has debt outstanding of $35 million and an interest rate of 8%. Brannon plans to reduce its debt by repaying $7 million in ironical at the end of each year for the next five years.
If Britton’s marginal corporate tax rate is 40%, what is the interest tax shield from Britton’s debt in each of the next five years? Year 0 1 2 3 4 5 Debt 35 28 21 14 Interest 2. 8 2. 24 1. 68 1. 12 0. 56 Tax Shield 0. 896 0. 672 0. 448 0. 224 interest only on this debt. Earner’s marginal tax rate is expected to be 35% for the foreseeable future. A. Suppose Earner pays interest of 6% per year on its debt. What is its annual interest tax shield? B. What is the present value of the interest tax shield, assuming its risk is the same as the loan? Suppose instead that the interest rate on the debt is 5%. What is the present value of the interest tax shield in this case? A. Interest tax shield = $10 x 6% x 35% = $0. 21 million b. UP(lintiest tax shield) = c. Interest tax shield = $10 x x 35% = $0. 175 million. Up=. 15-18. Kurd Manufacturing is currently an all-equity firm with 20 million shares outstanding and a stock price of $7. 50 per share. Although investors currently expect Kurd to remain an all-equity firm, Kurd plans to announce that it will borrow $50 million and use the funds to repurchase shares.
Kurd will pay interest only on this bet, and it has no further plans to increase or decrease the amount of debt. Kurd is subject to a 40% corporate tax rate. A. What is the market value of Guru’s existing assets before the announcement? B. What is the market value of Guru’s assets (including any tax shields) Just after the debt is issued, but before the shares are repurchased? C. What is Guru’s share price Just before the share repurchase? How many shares will Kurd repurchase? D. What are Guru’s market value balance sheet and share price after the share repurchase? A. Assets = Equity = $7. 50 x 20 = $150 million