Alpha Corporation and Beta Corporation are identical in every way except their c

Question

Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all equity firm, has 10.000 shares of stock outstanding, currently worth $20 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta's debt is $60, 000. and its cost of debt is 8 percent. Each firm is expected to have earnings before interest of $70, 000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 8 percent per year. a. What is the value of Alpha Corporation? (Do not round intermediate calculations.) Value of Alpha $ b. What is the value of Beta Corporation? (Do not round intermediate calculations.) Value of Beta $ c. What is the market value of Beta Corporation s equity? (Do not round intermediate calculations.) Market value of Beta's equity $ d. How much will it cost to purchase 25 percent of each firm's equity? (Do not round intermediate calculations.) e. Assuming each firm meets its earnings estimates, what will be the dollar return to each position in part (d) over the next year? (Do not round intermediate calculations.)

Explanation / Answer

A) Since Alpha corporation is an all equity firm, its value is equal to the market value of its outstanding shares. Alpha has 10,000shares outstanding worth$20/share

therefore the value of alpha corporation is $200,000 (10,000sh*$20/sh)

B) According to modigliani miller approach it states that in the absence of taxes the value of leveraged firm equals to the value of an otherwise identical unleveraged firm. since beta corporation is identical to alpha in every way except its capital structure . & neither firm pays taxes the value of both the firm should be equal.

therefore value of beta corporation is $200,000.

C) The value of the leveraged firm equals the market value of its debt +the market value of its equity

therefore the market value of equity of beta corporation = value of firm - market value of its debt

= $200,000 - $60,000 = $140,000 .

D) Since the market value of alpha corporation's equity is $200,000 it will cost $50,000(=25%of $200,000) to purchase 25% of the firms equity.

  Since the market value of beta corporation's equity is $140,000 it will cost $35,000(=25%of $140,000) to purchase 25% of the firms equity.

E) Since alpha corporation expects to earn $70,000 this year and owes no inerest payments, the dollar return to an investor who owns 25% odf the firm equity is expected to be $17,500(=25%of $70,000) over the next year.

while the beta corporation also expects to earn $70,000 before interest this year it must pay 8% interest on it's debt since the market value of beta corporation debt is $60,000 at begnining of the beta must pay $4,800 (8%of $60,000) in interest at the end of the year . therefore , the amount of the firm' s earnings available to equity holders is $65,200(=$70,000-$4,800). The dollar return to an investor who owns 25% of the firm equity is $16,300(=25%of $65,200).

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