Question

a) (2) Consider two firms: ABC: an all equity firm. It has 9 million common shares outstanding, worth $40/share. XYZ: is a levered firm with 4.6 million shares at $52.50/share. Its perpetual debt has a market value of $91 million and costs 8% a year. They are identical in every other way. Both firms expect to earn $29 million before interest/year in perpetuity, with each company distributing all earnings as dividends. Neither pay taxes. Assume the debt of XYZ is correctly priced. Which stock is a better buy? Show your work. b) (2) Company CDE is financed entirely with equity. The company is thinking of borrowing $900,000. The loan will be repaid in equal instalments over the next two years, and has a 8% interest rate. The tax rate is 35%. According to the MM proposition with taxes, what would be the increase in the value to CDE after the loan? Show your work.

Answer 1

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C W ENG 00:42 01-08-2020 66 34 Х QV38 QU QV QW QX QY QZ RA RB RC (a) levered 19 20 21 22 23 24 unlevered firm ABC firm XYZ EBIT 29 INTEREST 0 29 7.28 [91 X 8%] 21.72 NI = NET INCOME 29 25 26 27 A NO OF SHARES 9 4.6 B 40 52.5 PRICE VALUE OF EQUITY C=A*B 360 241.5 28 29 30 31 ROE = NI/C ROE = 8.06% 8.99% 32 33 ANSWER XYZ STOCK IS A BETTER BUY AS ROE IS HIGHER 34 35 36 37 38 39 40 41 42 pv, fv, annuity CAP STRU VALUE PM, PMT loan with points LOCK BOX DILUTION DOLLAR COST AVG EXPO NPER APR CPI ear FVA s2 pva |

00:51 W ENG 66 01-08-2020 34 Х IG607 . IA IB IC ID JE IF IG IH II 1J IK LOAN AMOUNT 900000 YEARS 2 RATE 8% PMT = PMT = PV/ ((1/r)*(1-(1/(1+r)^n))) 900000/ ((1/0.08)*(1-(1/(1+0.08)^2))) 504692.31 PMT = LOAN AMORTIZATION A B D= B-C E1= EO-D C= E0*8% INTEREST NUMBER AMOUNT PRINCIPAL PRINCIPAL 607 608 609 610 611 612 613 614 615 616 617 618 619 620 621 622 623 624 625 626 627 628 PAID PAID PAID BALANCE 0 1 504692.31 504692.31 72000.00 37384.62 432692.31 467307.69 900000.00 467307.69 0.00 2 PVIF @8% PV OF TAX SHIELD TAX SHIELD (1 * 35%) CALCULATION OF PV OF TAX SHIELD YEAR INTEREST (1) A 1 72000.00 2 37384.62 ANSWER INCREASE IN VALUE = PV OF TAX SHIELD B C B*C 25200 23333.33 0.9259 0.8573 13084.62 11217.95 34551.28 629 630 ► pv, fv, annuity CAP STRU VALUE PM, PMT loan with points LOCK BOX DILUTION DOLLAR COST AVG EXPO NPER APR CPI ear FVA s2 pva |