Capital Structure in a Perfect Market

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MBA 509 Recommended Chapter Questions 
These questions are the focus of what I am covering on the final exam.    Understand the answers to these questions and should not be surprised by anything on the exam.   

Chapter 14: Capital Structure in a Perfect Market 14-5. Suppose Alpha Industries and Omega Technologies have identical assets that generate identical cash flows. Alpha Industries is an all-equity firm, with 10 million shares outstanding that trade for a price of$22 per share. Omega Technologies has 20 million shares outstanding as well as debt of $60 million. 14-5-a. According to MM Proposition I, what is the stock price for Omega Technologies? V(alpha) = 10 x 22 = 220m = V(omega) = D + E E = 220 – 60 = 160m p = $8 per share.

14-5-b.Suppose Omega Technologies stock currently trades for $11 per share. What arbitrage opportunity is available? What assumptions are necessary to exploit this opportunity? Omega is overpriced. Sell 20 Omega, Buy 10 alpha and borrow 60. Initial = 220 – 220 + 60 = 60. Assumes we can trade shares at current prices & Assumes we can borrow at same terms as Omega (or own Omega debt and can sell at same price). 14-6. Cisoft is a highly profitable technology firm that currently has $5 billion in cash. The firm has decided to use this cash to repurchase shares from investors, and it has already announced these plans to investors. Currently, Cisoft is an all equity firm with 5 billion shares outstanding. These shares currently trade for $12 per share. Cisoft has issued no other securities except for stock options to its employees. The current market value of these options is $8 billion. 14-6-a. What is the value of Cisoft’s non-cash assets? Assets = cash + non-cash, Liabilities = equity + options. non-cash assets = equity + options – cash = 12 × 5 + 8 – 5 = 63 billion 14-6-b.With perfect capital markets, what is the market value of Cisoft’s equity after share repurchase? What is the value per share? Equity = 60 – 5 = 55. Repurchase 5b / 12 = 0.417b shares = 55 / 4.583 = $12 4.583 b shares remain Per share value

MBA 509 Recommended Chapter Questions 
These questions are the focus of what I am covering on the final exam.    Understand the answers to these questions and should not be surprised by anything on the exam.   

14-8. Explain what is wrong with the following argument: “If a firm issues debt that is risk free, because there is no possibility of default, the risk of the firm’s equity does not change. Therefore, risk-free debt allows the firm to get the benefit of a low cost of capital of debt without raising its cost of capital of equity.” Any leverage raises the equity cost of capital. In fact, risk-free leverage raises it the most (because it does not share any of the risk).

14-12. Hubbard Industries is an all-equity firm whose shares have an expected return of 10%. Hubbard does a leveraged recapitalization, issuing debt and repurchasing stock, until its debt=equity ratio is 0.60. Due to the increased risk, shareholders now expect a return of 13%. Assuming there are no taxes and Hubbard’s debt is risk free, what is the interest rate on the debt?

wacc = ru = 10% =

1 0.6 x ⇒ 1.6(10) − 13 = 3 = 0.6 x ⇒ x = 5% 13% + 1.6 1.6

14-17. Zelnor, Inc., is an all-equity firm with 100 million shares outstanding currently trading for $8.50 per share. Suppose Zelnor decides to grant a total of 10 million new shares to employees as part of a new compensation plan. The firm argues that this new compensation plan will motivate employees and is a better strategy that giving salary bonuses because it will not cost the firm anything. a. If the new compensation plan has no effect on the value of Zelnor’s assets, what will the share price of the new stock be once this plan is implemented? Assets = 850m.

New shares = 110 ⇒ price =

850 = $7.73 110

b. What is the cost of the plan for Zelnor’s investors? Why is issuing equity costly in this case?

Cost = 100(8.50 − 7.73) = 77m =...
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