FINA3070 Corporate Finance: Theory and Practice

Problem Set 1
(Due Date: 5:00pm, 30 September 2016)
Remarks:
1. Write or type your answers legibly on an A4-sized paper.
2. Please submit your assignment to the course drop box at CYT 2/F.
3. No late submission is accepted.

Question 1
Amarasuriya Lever, Inc., a prominent consumer products firm, is debating whether or not to
convert its all-equity capital structure to one that is 40 percent debt. Currently there are 2,000
shares outstanding and the price per share is $70. EBIT is expected to remain at $16,000 per
year forever. The interest rate on new debt is 8 percent, and there are no taxes.
a)

Ms. Tirichati, a shareholder of the firm, owns 100 shares of stock. What is her cash flow
under the current capital structure, assuming the firm has a dividend payout rate of 100
percent?

b)

What will Ms. Tirichatis cash flow be under the proposed capital structure of the firm?
Assume that she keeps all 100 of her shares.

c)

Suppose Amarasuriya Lever does convert, but Ms. Tirichati 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 Amarasuriya Levers choice of capital structure
is irrelevant.

Question 2
Alpha Corporation and Beta Corporation are identical in every way except their capital structures.
Alpha Corporation, an all-equity firm, has 5,000 shares of stock outstanding, currently worth $20
per share. Beta Corporation uses leverage in its capital structure. The market value of Betas
debt is $25,000, and its cost of debt is 12 percent. Each firm is expected to have earnings before
interest of $35,000 in perpetuity. Neither firm pays taxes. Assume that every investor can
borrow at 12 percent per year.
a)

What is the value of Alpha Corporation?

b)

What is the value of Beta Corporation?

c)

What is the market value of Beta Corporations equity?

d)

How much will it cost to purchase 20 percent of each firms equity?

e)

Assuming each firm meets its earnings estimates, what will be the dollar return to each
position in part (d) over the next year?

f)

Construct an investment strategy in which an investor purchases 20 percent of Alphas

equity and replicates both the cost and dollar return of purchasing 20 percent of Betas
equity.

g)

Is Alphas equity more or less risky than Betas equity? Explain.

Question 3
Locomotive Corporation is planning to repurchase part of its common stock by issuing corporate
debt. As a result, the firms debt-equity ratio is expected to rise from 40 percent to 50 percent.
The firm currently has $7.5 million worth of debt outstanding. The cost of this debt is 10 percent
per year. Locomotive expects to have an EBIT of $3.75 million per year in perpetuity.
Locomotive pays no taxes.
a)

What is the market value of Locomotive Corporation before and after the repurchase
announcement?

b)

What is the expected return on the firms equity before the announcement of the stock
repurchase plan?

c)

What is the expected return on the equity of an otherwise identical all-equity firm?

d)

What is the expected return on the firms equity after the announcement of the stock
repurchase plan?

Question 4
Lauria Manufacturing, Inc., plans to announce that it will issue $2 million of perpetual debt and
use the proceeds to repurchase common stock. The bonds will sell at par with a 6 percent annual
coupon rate. Lauria is currently an all-equity firm worth $10 million with 500,000 shares of
common stock outstanding. After the sale of the bonds, Lauria will maintain the new capital
structure indefinitely. Lauria currently generates annual pretax earnings of $1.5 million. This
level of earnings is expected to remain constant in perpetuity. Lauria is subject to a corporate tax
rate of 40 percent.
a) What is the expected return on Laurias equity before the announcement of the debt issue?
b) Construct Laurias market value balance sheet before the announcement of the debt issue.
What is the price per share of the firms equity?
c) Construct Laurias market value balance sheet immediately after the announcement of the
debt issue.
d) What is Laurias stock price per share immediately after the repurchase announcement?
e) How many shares will Lauria repurchase as a result of the debt issue? How many shares of
common stock will remain after the repurchase?
f) Construct the market value balance sheet after the restructuring.
g) What is the required return on Laurias equity after the restructuring?

Question 5
Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more
levered. Both companies will remain in business for one more year. The companies economists
agree that the probability of the continuation of the current expansion is 80 percent for the next
year, and the probability of a recession is 20 percent. If the expansion continues, each firm will
generate earnings before interest and taxes (EBIT) of $2 million. If a recession occurs, each firm
will generate earnings before interest and taxes (EBIT) of $800,000. Steinbergs debt obligation
requires the firm to pay $750,000 at the end of the year. Dietrichs debt obligation requires the
firm to pay $1 million at the end of the year. Neither firm pays taxes. Assume a discount rate of
13 percent.
a) What are the potential payoffs in one year to Steinbergs stockholders and bondholders?
What about those for Dietrichs?
b) Steinbergs CEO recently stated that Steinbergs value should be higher than Dietrichs
because the firm has less debt and therefore less bankruptcy risk. Do you agree or disagree
with this statement?