1 Consider two firms, With and Without, that have identical assets that generate
ID: 2758329 • Letter: 1
Question
1
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%. There is no corporate tax.Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as with. You have $5000 of your own money to invest and you plan on buying With stock. Using homemade (un)leverage you invest enough at the risk-free rate so that the payoff of your account will be the same as a $5000 investment in Without stock? The number of shares of With stock you purchased is closest to:
A100 B400 C1700 D800
2Assume that the corporate tax rate is 40%, the personal tax rate on income from equity is 20% the personal rate on interest income is 36%. The effective tax advantage of a corporate issuing debt would be closest to:
A10% B15% C25% D36%
3Flagstaff Enterprises expected to have free cash flow in the coming year of $8 million, and this free cash flow is expected to grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and it is in the 35% corporate tax bracket.
If Flagstaff currently maintains a .5 debt to equity ratio, then the value of Flagstaff's interest tax shield is closest to:
A,$11million b$18million C$10million D$24million
Explanation / Answer
Answer 1
Under MM, the total value -With or without must be the same.
Value (without) => 1 million *$24 => 24 Million
Value levere equity => Value(With) - Debt => $24M - $12M => $12M
Price per share => 12M / 2 => $6.00
So, the leverage ratio of with is 50% equity to 50% debt. To duplicate this in homemade leverage we need to have equal proportions in out portfolio, this means we need 50% equity and 50% from a margin loan. So $5000 is our equity we need to match it with $5000 in a margin loan. So the total invested is
$10,000 / $6 per share = 1667 shares
ie closet to 1700 shares ie option C.
Asnwer 2
The effective tax advantage of a corporate issuing debt would be closest to: 25%
Answer 3
R wacc => [(E/ E+D)*rE] + [(D/ E+D)*rD]
=> [ (1 / 1+0.5) * 0.13] + [ ( 0.5 / 1+0.5) * 0.7]
=> 0.11 or 11%
Value of Flagstaff => [$8/ (11% - 3%)] => $10 milion, Hence option C is correct.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.