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 ...view middle of the document...
How would you respond to this argument?
Returns are higher because risk is higher, the return fairly compensates for the risk. There is no free lunch.
13. Suppose Microsoft has no debt and an equity cost of capital of 9.2%. The average debt-to-value ratio for the software industry is 13%. What would its cost of equity be if it took on the average amount of debt for its industry at a cost of debt of 6%?
At a cost of debt of 6%:
re = ru + D/E (ru – rd)
re = 0.092 + 0.13/0.87 (0.092 – 0.06)
= 0.0968
= 9.68%
Chapter 15
Pelamed Pharmaceuticals has EBIT of $325 million in 2006. In addition, Pelamed has interest expenses of $125 million and a corporate tax rate of 40%.
a. What is Pelamed’s 2006 net income?
Net Income = EBIT – Interest – Taxes = (325 – 125) x (1 – 0.40) = $120 million
b. What is the total of Pelamed’s 2006 net income and interest payments?
Net income + Interest = 120 + 125 = $245 million
c. If Pelamed had no interest expenses, what would its 2006 net income be? How does it compare to your answer in part (b)?
Net income = EBIT – Taxes = 325 x (1...
