With and Without

Question 1 Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%. According to MM Proposition 1, what is the stock price for With?

Question 2 Johnson Paint stock has an expected return of 19% with a beta of 1.7, while Williamson Tire stock has an expected return of 14% with a beta of 1.2. Assume the CAMP is true.

(a). What is the expected return on the market?

(b). What is the risk-free rate?

(c). What is the market risk premium?

Question 3 Rumolt Motors has 30 million shares outstanding with a price of $15 per share. In addition, Rumolt has issued bonds with a total current market value of $150 million. Suppose Rumolt’s equity cost of capital is 10%, and its debt cost of capital is 5%.

(a). What is Rumolt’s cost of capital?

(b). If Rumolt’s corporate tax rate is 35%, what is its after-tax weighted average cost of capital?

Question 4 A project has an expected risky cash flow of $500, in year 4. The risk-free rate is 4%, the market rate of return is 13%, and the project’s beta is 1.2. Calculate the certainty equivalent cash flow for year 4.

Question 5 The equity accounts of Bio-Tech Company is as follows:

Common Shares ($1.00 par value) $10,000,000

Additional Paid in Capital $50,000,000

Retained Earnings $125,000,000

Treasury Shares at Cost $1,000,000

Net Common Equity 186,000,000

Suppose the firm sells 2,000,000 new (additional) shares at a price of $19 per share. What is the new value of Common Shares account? What is the new value of the additional paid-in-capital account? What is the new value of the net common equity?

Question 6 Hardmon Enterprises is currently an all-equity firm with an expected return of 12%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares.

(a). Suppose Hardmon borrows to the point that its debt-equity ratio is 0.50. With this amount of debt, the debt cost of capital is 6%. What will the expected return of equity be after this transaction?

(b). Suppose instead Hardmon borrows to the point that its debt-equity ratio is 1.50. With this amount of debt, Hardmon’s debt will be much riskier. As a result, the debt cost of capital will be 8%. What will the expected return of equity be in this case?

Question 7 A firm has zero debt in its capital structure. Its overall cost of capital is 10%. The firm is considering a new capital structure with 80% debt. The interest rate on the debt would be 8%. Assuming there are no taxes, what is the cost of equity capital with the new capital structure?

Question 8 Russo’s Gas Distributor, Inc. wants to determine the required return on a stock with a beta coefficient of 0.5. Assuming the risk free rate of 6 percent and the market return of 12 percent, compute the required rate of return.

Question 9 Consider a one-year, $1000, zero-coupon bond issued. Assume that the bond payoffs are uncertain. There is a 50% chance that the bond will repay its face value in full and a 50% chance that the bond will default and you will receive $900. Thus, you would expect to receive $950.Because of the uncertainty, the discount rate is 5.9%. Calculate the promised yield on the bond.