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Equity

Decent Essays

CHAPTER 17
Does Debt Policy Matter?
Answers to Practice Questions
1.

a.

The two firms have equal value; let V represent the total value of the firm.
Rosencrantz could buy one percent of Company B’s equity and borrow an amount equal to:
0.01 × (DA - DB) = 0.002V
This investment requires a net cash outlay of (0.007V) and provides a net cash return of:
(0.01 × Profits) – (0.003 × rf × V) where rf is the risk-free rate of interest on debt. Thus, the two investments are identical.

b.

Guildenstern could buy two percent of Company A’s equity and lend an amount equal to:
0.02 × (DA - DB) = 0.004V
This investment requires a net cash outlay of (0.018V) and provides a net cash return of:
(0.02 × Profits) – (0.002 × rf × V) …show more content…

Total income is positive:
$113,049 – $108,536 = $4,513

4.

a.

Before refinancing: r r



A
A

⎞ ⎛ E
⎞ ⎛ 40

⎞ ⎛ 300
× r ⎟ +⎜
⎟ ⎜ D + E × rE ⎟ = ⎜ 40 + 300 × 0.05 ⎟ + ⎜ 40 + 300 × 0.10 ⎟
⎟ ⎝
D
D+E

⎠ ⎝

⎠ ⎝


=⎜


D

= 0.0941

After refinancing: r =r
E

b.

A

+ (r

A

⎛ D⎞
⎛ 80 ⎞
− r )⎜ ⎟ = 0.0941 + (0.0941 − 0.05)⎜
⎟ = 0.1077 = 10.77%
D ⎜ E⎟
⎝ 260 ⎠
⎝ ⎠

Jacques owns a portfolio with €60,000 of his own money and €40,000 borrowed at the risk-free rate. The weights for this portfolio are 1.67 invested in Rastignac stock and –0.67 invested in the risk-free asset. The expected return for the portfolio is:
(1.67 × 0.10) + (–0.67 × 0.05) = 0.1335 = 13.35%

138

Let βE-B and βE-A represent the equity beta for Rastignac before and after the refinancing, respectively. The beta for Jacques’ portfolio before the refinancing is: (1.67 × βE-B). Use the following equation to determine the relationship between βE-B and βE-A:
⎛ D
⎞ ⎛ E

βA = ⎜
⎜ D + E × β D ⎟ + ⎜ D + E × β E-B ⎟
⎟ ⎜


⎠ ⎝


⎞ ⎛ 300
⎛ 40 βA = ⎜
× β E-B ⎟
× 0⎟ + ⎜
340
340

⎠ ⎝

340
× βA β E-B =
300
Also:


⎞ ⎛ E
⎛ D βA = ⎜

⎟ ⎜
⎜ D + E × β D ⎟ + ⎜ D + E × β E- A ⎟

⎠ ⎝


⎞ ⎛ 260
⎛ 80 βA = ⎜
× β E-B ⎟
× 0⎟ + ⎜

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