Fin 516 Week 2

FIN – 516 – WEEK 2 HOMEWORK ANSWER KEY - REVISED

PROBLEM BASED ON CHAPTER 15 – WACC & THE HAMADA FORMULA

Bickley’s Unlevered Beta:

bu = b / (1+(1-T) ( D/S) = 1.3/( 1+(1-.40)(30/70) = 1.3 / (1+(.60) (.4286)) = 1.03

Bickley’s New Levered Beta:

bL = bu X (1+(1-.40) ( 15/85) = 1.03 X (1 + (.60)(0.1765) = 1.14

Bickley’s WACC with the 30/70 Capital Structure:

Cost of Equity: ke = 3.5% +(1.3 X 7.5) = 13.25%

WACC = [7.5% X (1 - .40) X 30%] + [13.25% X 70%] = 1.35% + 9.28% = 10.63%

Bickley’s WACC with the 15/85 Capital Structure:

Cost of Equity: ke = 3.5% + (1.14 X 7.5) = 12.05%

WACC = [7.0% X (1-.40) X 15%] + [12.05% X 85%] = 0.63 + 10.24 = 10.87%

PROBLEM BASED ON CHAPTER 26 – MODIGLIANI & MILLER EXTENSION MODELS WITH GROWTH ASSUMPTIONS

Unlevered Value

Vu = $2.0 Million (1 + 6.5%) / (11.5% - 6.5%) = $42.6 Million

Levered Value

VL = $42.6 Million + [.08 X .35 X $8.0 Million / 11.5% - 6.5%]

VL = $42.6 Million + [224,000 / .05] = $47.08 Million

Therefore, Equity is : S = $47.08 Million – $8.0 Million = $39.08 Million

Expected Return by Levered Shareholder (Without Taxes)

rsL = 0.115 + (0.115 - .08) X $8 /$ 39.08 = 12.22%

With M & M with Taxes

VL = Vu + (T X D) = $42.6 + (.35 X $8.0) = $45.4 Million

Value of Equity: S = $45.4 – $8.0 = $37.4 Million

rsL = 0.115 + (.115 - .08) (1-.35) (8 / 37.4) = 0.115 + 0.005 = 11.99%