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 18,000 shares of stock outstanding, currently worth $30 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta’s debt is $68,000, and its cost of debt is 9 percent. Each firm is expected to have earnings before interest of $78,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 9 percent per year.

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.)

Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all equity firm, has 18,000 shares of stock outstanding, currently worth $30 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta’s debt is $68,000, and its cost of debt is 9 percent. Each firm is expected to have earnings before interest of $78,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 9 percent per year.

Explanation / Answer

Requirement a:

Value of Alpha Corporation:

Value of Alpha = Market value of equity (since it is an all equity firm)

= 18000 * 30

= $540000

Requirement b:

Value of beta Corporation:

Earnings before interest

$78000

Less: Interest (68000*9%)

-$6120

Earnings after interest

$71880

Value of Beta

= Earnings after interest / Borrowing rate

= 71880 / 9%

= $798667

Requirement c:

Market Value of Beta Corporation’s Equity

= Value of Beta – Value of debt

= $798667 - $68000

= $730667

Requirement d:

Cost to purchase 15% of Equity:

Alpha - $540000 * 15% = $81000

Beta - $730667 * 15% = $109600

Earnings before interest

$78000

Less: Interest (68000*9%)

-$6120

Earnings after interest

$71880

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