Scribd
Upload
81 views

Solving Some Numerical Questions

The document discusses capital structure theory and homemade leverage. It provides examples of two companies, Seether Inc. and ABC Co./XYZ Co., and discusses their capital structures, cash flows for shareholders, and costs of equity and WACC. It also discusses an example of the Veblen Company and Knight Company's capital structures and earnings streams to illustrate homemade leverage.

Uploaded by

VEDANT BASNYAT
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
81 views

Solving Some Numerical Questions

The document discusses capital structure theory and homemade leverage. It provides examples of two companies, Seether Inc. and ABC Co./XYZ Co., and discusses their capital structures, cash flows for shareholders, and costs of equity and WACC. It also discusses an example of the Veblen Company and Knight Company's capital structures and earnings streams to illustrate homemade leverage.

Uploaded by

VEDANT BASNYAT
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 9

Solving some Numerical questions

related to capital structure theory


8. Homemade Leverage
Seether, Inc., a prominent consumer products firm, is debating
whether to convert its all-equity capital structure to one that is
35 percent debt. Currently, there are 8,000 shares
outstanding, and the price per share is $55. EBIT is expected to
remain at $32,000 per year forever. The interest rate on new
debt is 8 percent, and there are no taxes.
a. Allison, a shareholder of the fi rm, owns 100 shares of stock.
What is her cash flow under the current capital structure,
assuming the fi rm has a dividend payout rate of 100 percent?
b. What will Allison’s cash flow be under the proposed capital
structure of the firm? Assume she keeps all 100 of her shares.
c. Suppose the company does convert, but Allison prefers the
current all-equity capital structure. Show how she could
unlever her shares of stock to recreate the original capital
structure.
d. Using your answer to part (c), explain why the company’s
choice of capital structure is irrelevant
9. Homemade Leverage and WACC
ABC Co. and XYZ Co. are identical fi rms in all respects except
for their capital structure. ABC is all equity financed with
$600,000 in stock. XYZ uses both stock and perpetual debt; its
stock is worth $300,000 and the interest rate on its debt is 8
percent. Both firms expect EBIT to be $80,000. Ignore taxes.
a. Rico owns $30,000 worth of XYZ’s stock. What rate of return
is he expecting?
b. Show how Rico could generate exactly the same cash flows
and rate of return by investing in ABC and using homemade
leverage.
c. What is the cost of equity for ABC? What is it for XYZ?
d. What is the WACC for ABC? For XYZ? What principle have you
illustrated?
Calculating WACC
Maxwell Industries has a debt–equity ratio of 1.5. Its WACC is
10 percent, and its cost of debt is 7 percent. The corporate tax
rate is 35 percent.
 
a. What is the company’s cost of equity capital? b. What is the
company’s unlevered cost of equity capital? c. What would
the cost of equity be if the debt–equity ratio were 2? What
if it were 1.0? What if it were zero?
18. Homemade Leverage
The Veblen Company and the Knight Company are identical in every respect except that
Veblen is not levered. Financial information for the two firms appears in the following table.
All earnings streams are perpetuities, and neither fi rm pays taxes. Both fi rms distribute all
earnings available to common stockholders immediately.
Veblen Knight
Projected operating income $ 400,000 $ 400,000
Year-end interest on debt 72,000
Market value of stock Market $2,500,000 1,632,000
value of debt 1,200,000
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 strategies are the same?
b. Given the two investment strategies in (a), which will investors choose? When will
this process cease?
The stock of the Omega Company is selling for Rs 150 per share.
The company then issues rights to subscribe to one new share at
Rs 100 for each four rights held. a. What is the theoretical value
of a right when the stock is selling rights-on? b. What is the
theoretical value of one share of stock when it goes ex-rights? c.
What is the theoretical value of a right when the stock sells ex-
rights at Rs 150? d. Saroj Koirala has Rs 15,000 at the time
Omega stock goes ex-rights at Rs 150 per share. He feels that the
price of the stock will rise to Rs 180 by the time the rights expire.
Compute his return on his Rs 15,000 if he (1) buys Omega stock
at Rs 150, or (2) buys the rights at the price computed in part c,
assuming his price expectations are valid

You might also like