You are on page 1of 2

Exercise

#1 BMW Corporation is comparing two different capital structures, an alli equity plan (Plan I)
and a levered plan (Plan II). Under Plan I, BMW would have 265,000 shares of stock outstanding.
Under Plan II there would be 185,000 shares of stock outstanding and $2.8 million in debt outstanding.
The interest rate on the debt is 10 percent and there are no taxes.
If EBIT is $750,000, which plan will result in the higher EPS? ________________
If EBIT is $1,500,000, which plan will result in the higher EPS? _______________
What is the break-even EBIT? ______________

Exercise #2 In Exercise 1 (above), use MM proposition I to find the price per share of equity under each
of the two proposed plans.
What is the stock price per share? $ ___________________
What is the value of the firm? $ ____________________

Exercise #3 BESTBUY Co. and STAPLES Co. are identical firms in all respects except for their capital
structure. BESTBUY is all equity financed with $750,000 in stock. STAPLES uses both stock and perpetual
debt; its stock is worth $375,000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to
be $86,000. Ignore taxes.
Richard owns $30,000 worth of STAPLE's stock. What rate of return is he expecting? __________%
Show how Skyler could generate exactly the same cash flows and rate of return by investing in BESTBUY
and using homemade leverage. Assume Richard sells all his shares in STAPLES. He then uses the $30,000
proceeds and borrows additional $30,000 to buy share in BESTBUY.
His BESTBUY dividends will be ____________ for

minus the interest charge of _____________

the total cash flow of ____________.

His return on a $30,000 investment is _______ %.

What is the cost of equity for BESTBUY? _______%

For STAPLES? _____________ %

What is the WACC for BESTBUY? __________%

For STAPLES? _____________ %

What principle have you illustrated? ______________________________

Exercise #4 FORD, Inc., has equity with a market value of $23 million and debt with a market value of
$7 million. Treasury bills that mature in one year yield 5 percent per year, and the expected return on
the market portfolio is 12 percent. The beta of FORD's equity is 1.15. The firm pays no taxes.
What is FORDs debt- equity ratio? _______________
What is the firms weighted average cost of capital? ________________%
What is the cost of capital for an otherwise identical all-equity firm? _________________%

Exercise #5 GRANNY Corp. has an EBIT rate of $975,000 per year that is expected to continue in
perpetuity. The unlevered cost of equity for the company is 14 percent, and the corporate tax rate is
35 percent. The company also has a perpetual bond issue outstanding with a market value of $1.9
million.
What is the value of the company? $ ___________________

Exercise #6 Yu Jianguo is the owner, president, and primary salesperson for Asa Manufacturing.
Because of this, the companys profits are driven by the amount of work Yu does. If he works 40 hours
each week, the companys EBIT will be $550,000 per year; if he works a 50- hour week, the companys
EBIT will be $625,000 per year. The company is currently worth $3.2 million. The company needs a cash
infusion of $1.3 million, and it can issue equity or issue debt with an interest rate of 8 percent. Assume
there are no corporate taxes.
What are the cash flows to Yu under each scenario?
Under Debt Issue:
40-hour week: $ _______________
50-hour week: $ _______________
Under Equity Issue:
40-hour week: $ _______________
50-hour week: $ _______________
Under which form of financing is Yu likely to work harder?
Under Debt Issue
Under Equity Issue
Exercise #7 MGM, Inc. has debt outstanding with a face value of $6 million. The value of the firm if it
were entirely financed by equity would be $17.85 million. The company also has 350,000 shares of
stock outstanding that sell at a price of $38 per share. The corporate tax rate is 35 percent.
What is the decrease in the value of the company due to expected bankruptcy costs? $________

You might also like