Capital Structure: Theory and Taxes. Consider two firms in the same industry tha

Question

Capital Structure: Theory and Taxes. Consider two firms in the same industry that operate in frictionless markets. Both firms, DebtHungry and Ner-aBorrower, have identical net operating income of $240000 per year. The riskiness of each company's assets suggests a fair weighted average cost of capital of 10 percent.

a. What is the value of each company?

b. If DebtHungry has borrowed $600,000 at a required rate of return of 4 percent, what is the fair required rate of return on the firm's equity?

c. Given that the expected rate of return on an investment at the corporate level in Ner-aBorrower is 10 percent, explain how you create an investment identical to an equity investment in Ner-aBorrower with only an investment in DebtHungry's equity and riskless debt (that earns 4 percent).

d. Suppose the actual market value of Ner-aBorrower is $3.0 million. Explain how you can exploit this mispricing via arbitrage.

Explanation / Answer

a. Value of firm = EBIT / Ko = 240000 / 0.1 = $2,400,000

b. Value of Equity of DebtHungry = Value of Firm - Value of Debt = 2,400,000 - 600,000 = $1,800,000
Net Income = Net operating Income - Interest = 240,000 - (600,000 x 4%) = $216,000
Required rate of return on the firm's equity = Net Income / Value of Equity = 216,000 / 1,800,000 = 0.12 or 12%

c. The investor will invest the own money in DebtHungry equity equal to the money invested in Ner-aBorrower.
Plus invest additional money in DebtHungry by taking riskless debt to earn the same level of income as before.

d. Ner-aBorrower value is more than what was expected. Thus, Ner-aBorrower is overvalued. Thus, the investor should sell Ner-aBorrower and buy DebtHungry.

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.