Baruch College, CUNY - FIN 4610

HW 16:

1)RAK, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $135,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. RAK has a tax rate of 35 percent.

1. 1. Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued.

1. 2. Calculate the percentage changes in EPS when the economy expands   or   enters   a recession.

1. 1. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization.

1. 2. Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession.

2.

DAR Corporation is comparing two different capital structures: an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 205,000 shares of stock outstanding. Under Plan II, there would be 155,000 shares of stock outstanding and $3.1 million in debt outstanding. The interest rate on the debt is 8 percent, and there are no taxes.

1. If EBIT is $600,000, what is the EPS for each plan?

2. If EBIT is $850,000, what is the EPS for each plan?

3. What is the break-even EBIT?

3.

Haskell Corp. is comparing two different capital structures. Plan I would result in 14,000 shares of stock and $100,000 in debt. Plan II would result in 10,800 shares of stock and $180,000 in debt. The interest rate on the debt is 8 percent. Assume that EBIT will be $90,000. An all-equity plan would result in 18,000 shares of stock outstanding. Ignore taxes.

What is the price per share of equity under Plan I? Plan II?

4.

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $725,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $362,500 and the interest rate on its debt is 8.2 percent. Both firms expect EBIT to be $74,000. Ignore taxes.

1. Rico owns $54,375 worth of XYZ’s stock. What rate of return is he expecting?

2. Suppose Rico invests in ABC Co. and uses homemade leverage. Calculate his total cash flow and

rate of return.

3. What is the cost of equity for ABC and XYZ?

4. What is the WACC for ABC and XY

5.

Once Bitten Corp. uses no debt. The weighted average cost of capital is 6.6 percent. If the current market value of the equity is $16 million and there are no taxes, what is EBIT?

6

Twice Shy Industries has a debt−equity ratio of 1.1. Its WACC is 8.2 percent, and its cost of debt is 6.4 percent. The corporate tax rate is 35 percent.

1. What is the company’s cost of equity capital?   

2. What is the company’s unlevered cost of equity capital?

1. 1. What would the cost of equity be if the debt−equity ratio were 2?

1. 2. What would the cost of equity be if the debt−equity ratio were 1.0?

1. 3. What would the cost of equity be if the debt−equity ratio were zero?

7.

Meyer & Co. expects its EBIT to be $81,000 every year forever. The firm can borrow at 8 percent. Meyer currently has no debt, and its cost of equity is 12 percent.

If the tax rate is 35 percent, what is the value of the firm?

What will the value be if the company borrows $132,000 and uses the proceeds to repurchase shares?

8.

Jet Corporation expects an EBIT of $33,000 every year forever. The company currently has no debt, and its cost of equity is 16 percent. The corporate tax rate is 35 percent.

a. What is the current value of the company?

1. 1. Suppose the company can borrow at 10 percent. What will the value of the firm be if the company takes on debt equal to 60 percent of its unlevered value?

1. 2. Suppose the company can borrow at 10 percent. What will the value of the firm be if the company takes on debt equal to 100 percent of its unlevered value?

1. 1. What will the value of the firm be if the company takes on debt equal to 60 percent of its levered value?