Knowledgeable and prolific space researchers

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Reference no: EM13743585

1. Aerotech, an aerospace technology research firm, announced this morning that it has hired the world's most knowledgeable and prolific space researchers. Before today Aerotech's stock had been selling for $100. Assume no other information is received over the next week and the stock market as a whole does not move.

a. What do you expect will happen to Aerotech's stock?

b. Consider the following scenarios:

1. The stock price jumps to $118 on the day of the announcement. In subsequent days it floats up to $123, then falls back to $116.

2. The stock price jumps to $116 and remains at that level.

3. The stock price gradually climbs to $116 over the next week.

Which scenario(s) indicate market efficiency? Which do not? Why?

2. TransTrust Corp. has changed how it accounts for inventory. Taxes are unaffected, although the resulting earnings report released this quarter is 20% higher than what it would have been under the old accounting system. There is no other surprise in the earnings report, and the change in the accounting treatment was publicly announced. If the market is efficient, will the stock price be higher when the market learns that the reported earnings are higher?

3. You are an entrepreneur starting a biotechnology firm. If your research is successful, the technology can be sold for $30 million. If your research is unsuccessful, it will be worth nothing. To fund your research, you need to raise $2 million. Investors are willing to provide you with $2 million in initial capital, in exchange for 50% of the unlevered equity in the firm.

a. What is the total market value of the firm without leverage?

b. Suppose you borrow $1 million. According to Modigliani-Miller, what fraction of the firm's equity must you sell to raise the additional $1 million you need?

c. What is the value of your share of the firm's equity in cases (a) and (b)?

4. Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company expects to earn $29 million before interest per year in perpetuity, with each company distributing all its earnings as dividends. Levered's perpetual debt has a market value of $91 million and costs 8% per year. Levered has 2.3 million shares outstanding, currently worth $105 per share. Unlevered has no debt and 4.5 million shares outstanding, currently worth $80 per share. Neither firm pays taxes. Is Levered's stock a better buy than Unlevered's stock?

5. Consider a company with the following balance sheet.

Asset value 100	Debt 30 (r_D=7.5%) (β_D=0.1)
	Equity 70 (r_E=15%) (β_E=1.1)
Asset value 100	Firm value 100

a. Calculate the cost of capital.

b. Calculate the asset beta.

c. Suppose the firm is contemplating investment in a project that has the same risk as the firm's existing business. What is the opportunity cost of capital for this project?

d. Suppose the firm is considering repaying all its debt and replacing it with equity. What would be the return on assets in this case?

e. Consider again the initial capital structure in the above table. Suppose the firm is considering issuing an additional 10% of debt and using the cash to repurchase 10% of its equity. Write the revised balance sheet.

f. What is the return on assets after the refinancing?

g. The change in financial structure affects the return on debt. Since the company has more debt than before, the debt-holders are likely to demand a higher interest rate. Suppose this increases from 7.5% to 7.875%. What is the new return required by shareholders?

h. What is the equity beta after the refinancing?

6. Balfurd Cleaners is reviewing its capital structure. The company has no leverage and all the EBIT is paid as dividends to the stockholders. There are no taxes. The company currently has 1,000 shares, and the price of each share is $10; the market value of shares is therefore $10,000. The expected earnings and dividends per share are $1.50. Since the firm expects to produce a level of stream earnings in perpetuity, the expected return on the share is equal to the earnings-price ratio, 1.50/10=15%. However, the expected earnings per share is by no means certain. In fact, there are 4 possible outcomes for EBIT and earnings per share, presented in the table below.

	Outcomes
	1	2	3	4
EBIT ($)	500	1,000	1,500	2,000
Earnings per share ($)	0.50	1.00	1.50	2.00
Return on shares (%)	5	10	15	20

Ms. Balfurd, the firm's president, is convinced that shareholders would be better off if the company had equal proportions of debt and equity. She therefore proposes to issue $5,000 of debt at an interest rate of 10% and use the proceeds to repurchase 500 shares. To support this proposal, Ms. Balfurd has analyzed the situation under different assumptions.

	Outcomes
	1	2	3	4
EBIT ($)	500	1,000	1,500	2,000
Interest ($)	500	500	500	500
Equity earnings ($)	0	500	1,000	1,500
Earnings per share ($)	0	1.00	2.00	3.00
Return on shares (%)	0	10	20	30

a. Plot the data in the two tables above, with EBIT on the x axis and EPS on the y axis (you should get two lines, one for each table).

b. Ms. Balfurd argues that the chart clearly shows that the effect of leverage depends on the company's income. Why? Explain.

c. Ms. Balfurd also argues that, since the company expects its EBIT to be above the $1,000 break-even point in the chart, it is best to go ahead with the $5,000 debt issue. Is this argument correct? To show this, find an alternative strategy that yields the same payoff as the investor would get by buying one share in the levered company (based on a comparison of net earnings and return on investment).

Reference no: EM13743585

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