Financial Management – Fin 534

Chapter 14

3. Acort Industries owns assets that will have an 80% probability of having a market value of $50million in one year. There is a 20% chance that the assets will be worth only $20 million. The current risk-free rate is 5%, and Acort’s assets have a cost of capital of 10%.

a. If Acort is unlevered, what is the current market value of its equity?

E {value in one year} = 0.8(50) + 0.2 (20) = 44. E = 44/1.10 = $40m

b. Suppose instead that Acort has debt with a face value of $20 million due in one year. According to MM, what is the value of Acort’s equity in this case?

D = 20/1.05 = 19.048. Therefore, E = 40 – 19.048 = $20.952m

c. What is the expected return of Acort’s equity without leverage? What is the expected return of Acort’s equity with leverage?

Without leverage, r = 44/40 – 1 = 10%, with leverage, r = 44 – 20/20.952 – 1 = 14.55%

d. What is the lowest possible realized return of Acort’s equity with and without leverage?

Without leverage, r = 20/40 – 1 = 50%, with leverage, r = 0/20.952 – 1 = -100%

12. Hardmon Enterprises is currently an all-equity firm with an expected return of 12%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares.

a. Suppose Hardmon borrows to the point that its debt-equity ratio is 0.50. With this amount of debt, the debt cost of capital is 6%. What will the expected return of equity be after this transaction?

re = ru + d/e(ru – rd) = 12% + 0.50 (12% - 6%) = 15%

b. Suppose instead Hardmon borrows to the point that its debt-equity ratio is 1.50. With this amount of debt, Hardmon’s debt will be much riskier. As a result, the debt cost of capital will be 8%. What will the expected return of equity be in this case?

re = 125 + 1.50(12% - 8%) = 18%

c. A senior manager argues that it is in the best interest of the shareholders to choose the capital structure that leads to the highest expected return for the stock. How would you respond to this argument?

Returns...