Homework answers / question archive / FIN5FMA Financial Management Question 1) Money Inc

FIN5FMA Financial Management Question 1) Money Inc

Finance

Share With

FIN5FMA Financial Management

Question 1) Money Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25% higher. If there is a recession, then EBIT will be 40 percent lower. Money is considering a $99,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 5000 shares outstanding. Ignore taxes for this problem.

(a) Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also calculate the percentage change in EPS when the economy expands or enters a recession.

(b) Repeat part (a) assuming that Money goes through with recapitalization. What do you observe?

Question 2) Kolby Corp. is comparing two different capital structures. Plan I would result in 900 shares of stock and $65,700 in debt. Plan II would result in 1,900 shares of stock and $29,200 in debt. The interest rate on the debt is 10 percent.

a. Ignoring taxes compare both of these plans to an all-equity plan assuming that EBIT will be $8,500. The all equity would result in 2700 shares outstanding. Which of the three plans has the highest EPS? The lowest?

b. In part (a) what are the break-even levels of EBIT for each plan compared to that for an all-equity plan? Is one higher than the other? Why?

c. Ignoring taxes, when will EPS be identical for plans I and II?

Question 3) ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $750,000 in stock. XYZ uses both stock and perpetual debt, its stock is worth $375,000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $86,000. Ignore taxes.

a. Richard owns $30,000 worth of XYZ’s stock. What rate of return is he expecting?

b. Show how Richard could generate exactly the same cash flows and rate of return by investing in ABC 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?