Homework 4
FINA 4330
Fall 2011
Professor:GiorgoSertsios
Instructions: Answer all the questions, showing your work. Submit your answers by Sunday, November27, via email to Libby Yi: have to submit a Words file, using the equation editor to insert the formulas. Scanned hand-written answers are not allowed and are not going to be considered.
Submissions can be in groups of up to 4 people, within the same section. When submitting your homework, please mention in the subject line of the email the names of the participants as well as the section. Put that information in your homework as well.The homework has 30 points.
Q1) State and explain MM's Proposition II.(4 points)
Q2)Learn and Earn Company is financed entirely by Common stock that is priced to offer a 20% expected return. The stock price is $60, the earnings per share are $12 and there are no corporate taxes. If the company repurchases 50% of the stock and substitutes it with an equal value of debt yielding 8%:
a)What is the expected return on the common stock after refinancing? (4 points)
b)What is the expected earnings per share value after refinancing? (4 points)
Q3) Assume a company is fully financed by equity and has a return on assets of 12%. The company is thinking of changing its capital structure to 50% debt, which pays an interest of 5%. Assume a tax rate of 35%.
a)What is the return on assets after the company increases its leverage? (2 points)
b)Compute the return on equityafter the company increases its leverage (2 points)
c)What would the WACC be in absence of taxesafter the company increases its leverage? (2 points)
d)What would the WACC be in presence of a 35% corporate tax after the company increases its leverage? (2 points)
Q4) A company’s market value of debt and equity are $200 and $1,000 respectively. The company decides to undergo a debt-equity swap by increasing its leverage by 300. Assuming a corporate tax rate of 35%, and no costs of financial distress:
a)What is the PV of the tax shields obtained through the recapitalization? (3 points)
b)What is the market value of equity after the recapitalization? (3 points)
c)Are equity holders better off or worst off after the debt-equity swap? Explain. (3 points)
Q5)Discuss some examples of the conflicts of interest that may arise between bondholders and stockholders when a firm is in financial distress.(5 points)
Q6) Explain the pecking order theory of capital structure.(4 points)