JEM034 Corporate Finance

(tutorial 2)

Matěj Kuc
Petr Polák
Karolína Růžičková
Diana Žigraiová February 23, 2016
Exercise 1

 Suppose Alpha Industries and Omega Technology

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 Technology has 20 million
shares outstanding as well as debt of $60 million
(Berk and DeMarzo).
 According to MM Proposition I, what is the stock price for
Omega Technology? Suppose no taxes.

2
Exercise 2

 Global Pistons (GP) has common stock with a market

value of $200 million and debt with a value of $100
million. Investors expect a 15% return on the stock
and a 6% return on the debt. Assume perfect capital
markets (Berk and DeMarzo).
 Suppose GP issues $100 million of new stock to buy back
the debt. What is the expected return of the stock after
this transaction?
 Suppose instead GP issues $50 million of new debt to
repurchase stock. If the risk of the debt does not change,
what is the expected return of the stock after this
transaction?

3
Exercise 3

 The market value of a firm with $500,000 of debt is

$1,700,000. The pre-tax interest rate on debt is 10%
p.a., and the company is in the 34% tax bracket; the
company expects $306,000 of earnings before interest
and taxes every year in perpetuity.
 What would be the value of the firm if it was financed
entirely with equity?
 What amount of the firm’s annual earnings is available
to stockholders?

4
Exercise 4

 Gibson, Inc., expects perpetual earnings before interest

and taxes of $1.2 mil. per year; the firm’s pre-tax cost of
debt is 8% p.a., and its annual interest expense is
$200,000; the company analysts estimate that the
unlevered cost of Gibson’s equity is 12%; Gibson is
subject to a 35% corporate tax rate.
 What is the value of this firm?
 If there are no costs of financial distress or bankruptcy,
what percentage of the firm’s capital structure would
be financed by debt?

5
Exercise 5

 The Holland Company expects perpetual EBIT of $4

mil. per year; the firm’s after-tax, all-equity discount
rate (r0) is 15%; company is subject to the tax rate of
35%; the pre-tax cost of the firm’s debt capital is
10% p.a., and the firm has $10 mil. of debt in its
capital structure.
 What is Holland’s value?
 What is Holland’s cost of equity (re)?
 What is Holland’s WACC?