REVISION QUESTIONS

1. In a world with no taxes, no transaction costs, and no costs of financial distress, is the
following statement true, false, or uncertain? If a firm issues equity to repurchase some
of its debt, the price per share of the firm’s stock will rise because the shares are less risky.
Explain.

In a world with no taxes, no transaction costs, and no costs of financial distress, is the
following statement true, false, or uncertain? If a firm issues equity to repurchase some
of its debt, the price per share of the firm’s stock will rise because the shares are less risky.
Explain.

2. In a world with no taxes, no transaction costs, and no costs of financial distress, is the
following statement true, false, or uncertain? Moderate borrowing will not increase the
required return on a firm’s equity. Explain.

False. Modigliani-Miller Proposition II (No Taxes) states that the required return on a
firm’s equity is positively related to the firm’s debt-equity ratio [RS = R0 + (B/S)(R0 – RB)].
Therefore, any increase in the amount of debt in a firm’s capital structure will increase the
required return on the firm’s equity.

3. Explain what is meant by business and financial risk. Suppose firm A has greater business
risk than firm B. Is it true that firm A also has a higher cost of equity capital? Explain.

Business risk is the equity risk arising from the nature of the firm’s operating activity and
is directly related to the systematic risk of the firm’s assets. Financial risk is the equity risk
that is due entirely to the firm’s chosen capital structure. As financial leverage, or the use
of debt financing, increases, so does financial risk and, hence, the overall risk of the equity.
Thus, Firm B could have a higher cost of equity if it uses greater leverage.

4. Why is the use of debt financing referred to as financial “leverage”?

It’s called leverage (or “gearing” in the UK) because it magnifies gains or losses

5. What is homemade leverage?

Homemade leverage refers to the use of borrowing on the personal level as opposed to
the corporate level.

6. Star, Inc., a prominent consumer products firm, is debating whether or not to convert
its all-equity capital structure to one that is 40 percent debt. Currently there are 5,000
 shares outstanding and the price per share is $65. EBIT is expected to remain at
$37,500 per year forever. The interest rate on new debt is 8 percent, and there are no
taxes.

1. Ms. Brown, a shareholder of the firm, owns 100 shares of stock. What is her cash
flow under the current capital structure, assuming the firm has a dividend payout
rate of 100 percent?

2. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm?
Assume that she keeps all 100 of her shares.

3. Suppose Star does convert, but Ms. Brown prefers the current all-equity capital
structure.

a. The earnings per share are:

EPS = $37,500/5,000 shares

EPS = $7.50

So, the cash flow for the company is:

Cash flow = $7.50(100 shares)

Cash flow = $750

b. To determine the cash flow to the shareholder, we need to determine the EPS of the firm
under the proposed capital structure. The market value of the firm is:

V = $65(5,000)
V = $325,000

Under the proposed capital structure, the firm will raise new debt in the amount of:

D = 0.40($325,000)
D = $130,000

This means the number of shares repurchased will be:

Shares repurchased = $130,000/$65

Shares repurchased = 2,000

Under the new capital structure, the company will have to make an interest payment on
the new debt. The net income with the interest payment will be:

NI = $37,500 – .08($130,000)
NI = $27,100

This means the EPS under the new capital structure will be:

EPS = $27,100 / 3,000 shares

EPS = $9.03
 Since all earnings are paid as dividends, the shareholder will receive:

Shareholder cash flow = $9.03(100 shares)

Shareholder cash flow = $903.33

c. To replicate the proposed capital structure, the shareholder should sell 40 percent of their
shares, or 40 shares, and lend the proceeds at 8 percent. The shareholder will have an
interest cash flow of:

Interest cash flow = 40($65)(.08)

Interest cash flow = $208.00

The shareholder will receive dividend payments on the remaining 60 shares, so the
dividends received will be:

Dividends received = $9.03(60 shares)

Dividends received = $542.00

The total cash flow for the shareholder under these assumptions will be:

Total cash flow = $208 + 542

Total cash flow = $750

This is the same cash flow we calculated in part a.

d. The capital structure is irrelevant because shareholders can create their own leverage or
unlever the stock to create the payoff they desire, regardless of the capital structure the
firm actually chooses.

7. ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure.
ABC is all equity financed with $800,000 in stock. XYZ uses both stock and perpetual
debt; its stock is worth $400,000 and the interest rate on its debt is 10 percent.
Both firms expect EBIT to be $95,000. Ignore taxes.

1. Richard owns $30,000 worth of XYZ’s stock. What rate of return is he

expecting?

2. Show how Richard could generate exactly the same cash flows and rate of
return by investing in ABC and using homemade leverage.

3. What is the cost of equity for ABC? What is it for XYZ?

4. What is the WACC for ABC? For XYZ? What principle have you illustrated?
Show how she could unlever her shares of stock to recreate the original capital
structure.
Using your answer to part (c), explain why Star’s choice of capital structure is
irrelevant.
a. The rate of return earned will be the dividend yield. The company has debt, so it must make
an interest payment. The net income for the company is:

NI = $95,000 – .10($400,000)
NI = $55,000

The investor will receive dividends in proportion to the percentage of the company’s shares
they own.

The total dividends received by the shareholder will be:

Dividends received = $55,000($30,000/$400,000)
Dividends received = $4,125

So the return the shareholder expects is:

R = $4,125/$30,000
R = .1375 or 13.75%

b. To generate exactly the same cash flows in the other company, the shareholder needs to
match the capital structure of ABC. The shareholders should sell all shares in XYZ. This
will net $30,000. The shareholder should then borrow $30,000. This will create an
interest cash flow of:

Interest cash flow = .10(–$30,000)

Interest cash flow = –$3,000

The investor should then use the proceeds of the stock sale and the loan to buy shares in
ABC. The investor will receive dividends in proportion to the percentage of the
company’s share they own. The total dividends received by the shareholder will be:

Dividends received = $95,000($60,000/$800,000)

Dividends received = $7,125

The total cash flow for the shareholder will be:

Total cash flow = $7,300 – 3,000

Total cash flow = $4,125

The shareholders return in this case will be:

R = $4,125/$30,000
R = .1375 or 13.75%

c. ABC is an all-equity company, so:

RE = RA = $95,000/$800,000
RE = .1188 or 11.88%

To find the cost of equity for XYZ, we need to use M&M Proposition II, so:

RE = RA + (RA – RD)(D/E)(1 – tC)

RE = .1188 + (.1188 – .10)(1)(1)
 RE = .1375 or 13.75%

8. Acetate, Inc., has equity with a market value of $35 million and debt with a market
value of $14 million. Treasury bills that mature in one year yield 6 percent per
year, and the expected return on the market portfolio is 13 percent. The beta of
Acetate’s equity is 1.15. The firm pays no taxes.

1. What is Acetate’s debt–equity ratio?

2. What is the firm’s weighted average cost of capital?

3. What is the cost of capital for an otherwise identical all-equity firm?

a. A firm’s debt-equity ratio is the market value of the firm’s debt divided by the market value
of a firm’s equity. So, the debt-equity ratio of the company is:
Debt-equity ratio = MV of debt / MV of equity
Debt-equity ratio = $14,000,000 / $35,000,000
Debt-equity ratio = .40

b. We first need to calculate the cost of equity. To do this, we can use the CAPM, which
gives us:
RS = RF + [E(RM) – RF]
RS = .06 + 1.15(.13 – .06)
RS = .1405 or 14.05%

We need to remember that an assumption of the Modigliani-Miller theorem is that the

company debt is risk-free, so we can use the Treasury bill rate as the cost of debt for the
company. In the absence of taxes, a firm’s weighted average cost of capital is equal to:
RWACC = [B / (B + S)]RB + [S / (B + S)]RS
RWACC = ($14,000,000/$49,000,000)(.06) + ($35,000,000/$49,000,000)(.1405)
RWACC = .1175 or 11.75%

c. According to Modigliani-Miller Proposition II with no taxes:

RS = R0 + (B/S)(R0 – RB)
.1405 = R0 + (.40)(R0 – .06)
R0 = .1175 or 11.75%
This is consistent with Modigliani-Miller’s proposition that, in the absence of taxes, the
cost of capital for an all-equity firm is equal to the weighted average cost of capital of an
otherwise identical levered firm.

9. Williamson, Inc., has a debt–equity ratio of 2.5. The firm’s weighted average cost of
capital is 15 percent, and its pretax cost of debt is 10 percent. Williamson is subject
to a corporate tax rate of 35 percent.

1. What is Williamson’s cost of equity capital?

2. What is Williamson’s unlevered cost of equity capital?

 3. What would Williamson’s weighted average cost of capital be if the firm’s
debt–equity ratio were .75? What if it were 1.5?

a. In a world with corporate taxes, a firm’s weighted average cost of capital is equal to:

RWACC = [B / (B+S)](1 – tC)RB + [S / (B+S)]RS

We do not have the company’s debt-to-value ratio or the equity-to-value ratio, but we
can calculate either from the debt-to-equity ratio. With the given debt-equity ratio, we
know the company has 2.5 dollars of debt for every dollar of equity. Since we only need
the ratio of debt-to-value and equity-to-value, we can say:
B / (B+S) = 2.5 / (2.5 + 1) = .7143
S / (B+S) = 1 / (2.5 + 1) = .2857

We can now use the weighted average cost of capital equation to find the cost of equity,
which is:
.15 = (.7143)(1 – 0.35)(.10) + (.2857)(RS)
RS = .3625 or 36.25%

b. We can use Modigliani-Miller Proposition II with corporate taxes to find the unlevered
cost of equity. Doing so, we find:
RS = R0 + (B/S)(R0 – RB)(1 – tC)
.3625 = R0 + (2.5)(R0 – .10)(1 – .35)
R0 = .2000 or 20.00%
c. We first need to find the debt-to-value ratio and the equity-to-value ratio. We can then
use the cost of levered equity equation with taxes, and finally the weighted average cost
of capital equation. So:

If debt-equity = .75
B / (B+S) = .75 / (.75 + 1) = .4286
S / (B+S) = 1 / (.75 + 1) = .5714

The cost of levered equity will be:

RS = R0 + (B/S)(R0 – RB)(1 – tC)
RS = .20 + (.75)(.20 – .10)(1 – .35)
RS = .2488 or 24.88%
 And the weighted average cost of capital will be:
RWACC = [B / (B+S)](1 – tC)RB + [S / (B+S)]RS
RWACC = (.4286)(1 – .35)(.10) + (.5714)(.2488)
RWACC = .17

If debt-equity =1.50
B / (B+S) = 1.50 / (1.50 + 1) = .6000
E / (B+S) = 1 / (1.50 + 1) = .4000

The cost of levered equity will be:

RS = R0 + (B/S)(R0 – RB)(1 – tC)
RS = .20 + (1.50)(.20 – .10)(1 – .35)
RS = .2975 or 29.75%

And the weighted average cost of capital will be:

RWACC = [B / (B+S)](1 – tC)RB + [S / (B+S)]RS
RWACC = (.6000)(1 – .35)(.10) + (.4000)(.2975)
RWACC = .1580 or 15.80%

10. Assume a firm’s debt is risk-free, so that the cost of debt equals the risk-free rate, Rf.
Define βA as the firm’s asset beta—that is, the systematic risk of the firm’s assets.
Define βS to be the beta of the firm’s equity. Use the capital asset pricing model,
CAPM, along with MM Proposition II to show that βS = β A × (1 + B/S), where
B/S is the debt–equity ratio. Assume the tax rate is zero.

M&M Proposition II, with no taxes is:

RE = RA + (RA – Rf)(B/S)

Note that we use the risk-free rate as the return on debt. This is an important assumption
of M&M Proposition II. The CAPM to calculate the cost of equity is expressed as:

RE = E(RM – Rf) + Rf

We can rewrite the CAPM to express the return on an unlevered company as:

R0 = A(RM – Rf) + Rf
 We can now substitute the CAPM for an unlevered company into M&M Proposition II.
Doing so and rearranging the terms we get:

RE = A(RM – Rf) + Rf + [A(RM – Rf) + Rf – Rf](B/S)

RE = A(RM – Rf) + Rf + [A(RM – Rf)](B/S)
RE = (1 + B/S)A(RM – Rf) + Rf

Now we set this equation equal to the CAPM equation to calculate the cost of equity and
reduce:

E(RM – Rf) + Rf = (1 + B/S)A(RM – Rf) + Rf

E(RM – Rf) = (1 + B/S)A(RM – Rf)
E = A(1 + B/S)

STOCK VALUATION

1. Suppose a company has a preferred stock issue and a common stock issue. Both have
just paid a $2 dividend. Which do you think will have a higher price, a share of the
preferred or a share of the common?

The common stock probably has a higher price because the dividend can grow, whereas it is
fixed on the preferred. However, the preferred is less risky because of the dividend and
liquidation preference, so it is possible the preferred could be worth more, depending on
the circumstances.

2. What are the three factors that determine a company’s price–earnings ratio?

The three factors are: 1) The company’s future growth opportunities. 2) The company’s level
of risk, which determines the interest rate used to discount cash flows. 3) The accounting
method used.

3. Evaluate the following statement: Managers should not focus on the current stock value
because doing so will lead to an overemphasis on short-term profits at the expense of
long-term profits.

Presumably, the current stock value reflects the risk, timing and magnitude of all
future cash flows, both short-term and long-term. If this is correct, then the statement is
false.

4. Suppose you know that a company’s stock currently sells for $64 per share and the
required return on the stock is 13 percent. You also know that the total return on the
stock is evenly divided between a capital gains yield and a dividend yield. If it’s the
 company’s policy to always maintain a constant growth rate in its dividends, what is the
current dividend per share?

We know the stock has a required return of 13 percent, and the dividend and capital gains
yield are equal, so:

Dividend yield = 1/2(.13) = .065 = Capital gains yield

Now we know both the dividend yield and capital gains yield. The dividend is simply the
stock price times the dividend yield, so:

D1 = .065($64) = $4.16

This is the dividend next year. The question asks for the dividend this year. Using the
relationship between the dividend this year and the dividend next year:

D1 = D0(1 + g)

We can solve for the dividend that was just paid:

$4.16 = D0 (1 + .065)

D0 = $4.16 / 1.065 = $3.91

5. Gruber Corp. pays a constant $11 dividend on its stock. The company will maintain this
dividend for the next nine years and will then cease paying dividends forever. If the
required return on this stock is 10 percent, what is the current share price?

The price of any financial instrument is the PV of the future cash flows. The future
dividends of this stock are an annuity for 9 years, so the price of the stock is the PVA, which
will be:

P0 = $11(PVIFA10%,9) = $63.35

6. Bucksnort, Inc., has an odd dividend policy. The company has just paid a dividend of
$10 per share and has announced that it will increase the dividend by $3 per share for
each of the next five years, and then never pay another dividend. If you require an 11
percent return on the company’s stock, how much will you pay for a share today?

The price of a stock is the PV of the future dividends. This stock is paying five dividends,
so the price of the stock is the PV of these dividends using the required return. The price
of the stock is:

P0 = $13 / 1.11 + $16 / 1.112 + $19 / 1.113 + $22 / 1.114 + $25 / 1.115 = $67.92

7. Consider four different stocks, all of which have a required return of 20 percent and a
most recent dividend of $4.50 per share. Stocks W, X, and Y are expected to maintain
constant growth rates in dividends for the foreseeable future of 10 percent, 0 percent,
and –5 percent per year, respectively. Stock Z is a growth stock that will increase its
dividend by 30 percent for the next two years and then maintain a constant 8 percent
 growth rate thereafter. What is the dividend yield for each of these four stocks? What is
the expected capital gains yield? Discuss the relationship among the various returns that
you find for each of these stocks.

We are asked to find the dividend yield and capital gains yield for each of the stocks. All of
the stocks have a 20 percent required return, which is the sum of the dividend yield and
the capital gains yield. To find the components of the total return, we need to find the stock
price for each stock. Using this stock price and the dividend, we can calculate the dividend
yield. The capital gains yield for the stock will be the total return (required return) minus
the dividend yield.

W: P0 = D0(1 + g) / (R – g) = $4.50(1.10)/(.20 – .10) = $49.50

Dividend yield = D1/P0 = 4.50(1.10)/$49.50 = .10 or 10%

Capital gains yield = .20 – .10 = .10 or 10%

X: P0 = D0(1 + g) / (R – g) = $4.50/(.20 – 0) = $22.50

Dividend yield = D1/P0 = $4.50/$22.50 = .20 or 20%

Capital gains yield = .20 – .20 = 0%

Y: P0 = D0(1 + g) / (R – g) = $4.50(1 – .05)/(.20 + .05) = $17.10

Dividend yield = D1/P0 = $4.50(0.95)/$17.10 = .25 or 25%

Capital gains yield = .20 – .25 = –.05 or –5%

Z: P2 = D2(1 + g) / (R – g) = D0(1 + g1)2(1 + g2)/(R – g2) = $4.50(1.30)2(1.08)/(.20 –

.08)
P2 = $68.45

P0 = $4.50 (1.30) / (1.20) + $4.50 (1.30)2 / (1.20)2 + $68.45 / (1.20)2

P0 = $57.69

Dividend yield = D1/P0 = $4.50(1.30)/$57.69 = .1014 or 10.14%

Capital gains yield = .20 – .1014 = .0986 or 9.86%

In all cases, the required return is 20 percent, but the return is distributed differently
between current income and capital gains. High-growth stocks have an appreciable capital
gains component but a relatively small current income yield; conversely, mature, negative-
growth stocks provide a high current income but also price depreciation over time.

8. Most corporations pay quarterly dividends on their common stock rather than annual
dividends. Barring any unusual circumstances during the year, the board raises, lowers,
or maintains the current dividend once a year and then pays this dividend out in equal
quarterly installments to its shareholders.

i. Suppose a company currently pays a $3.60 annual dividend on its common

stock in a single annual installment, and management plans on raising this
 dividend by 5 percent per year indefinitely. If the required return on this stock is
14 percent, what is the current share price?

ii. Now suppose that the company in (a) actually pays its annual dividend in equal
quarterly installments; thus, this company has just paid a $.90 dividend per share,
as it has for the previous three quarters. What is your value for the current share
price now? (Hint: Find the equivalent annual end-of-year dividend for each year.)
Comment on whether or not you think that this model of stock valuation is
appropriate.

a. Using the constant growth model, the price of the stock paying annual dividends will be:

P0 = D0(1 + g) / (R – g) = $3.60(1.05)/(.14 – .05) = $42.00

b. If the company pays quarterly dividends instead of annual dividends, the quarterly
dividend will be one-fourth of annual dividend, or:

Quarterly dividend: $3.60(1.05)/4 = $0.9450

To find the equivalent annual dividend, we must assume that the quarterly dividends
are reinvested at the required return. We can then use this interest rate to find the
equivalent annual dividend. In other words, when we receive the quarterly dividend,
we reinvest it at the required return on the stock. So, the effective quarterly rate is:

Effective quarterly rate: 1.14.25 – 1 = .0333

The effective annual dividend will be the FVA of the quarterly dividend payments at the
effective quarterly required return. In this case, the effective annual dividend will be:
Effective D1 = $0.9450(FVIFA3.33%,4) = $3.97

Now, we can use the constant growth model to find the current stock price as:
P0 = $3.97/(.14 – .05) = $44.14
Note that we cannot simply find the quarterly effective required return and growth rate
to find the value of the stock. This would assume the dividends increased each quarter,
not each year.