Homework Assignment 2
Topic: Capital and Capital Structure and Payout Policy
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* All subquestions have to be worked on. If you do not answer 1 subquestion, I will deduct 1 point, 2 unanswered subquestions ...view middle of the document...
Kurz will pay interest only on this debt, and it has no further plans to increase or decrease the amount of debt. Kurz is subject to a 40% corporate tax rate.
a. What is the market value of Kurz’s existing assets before the announcement?
b. What is the market value of Kurz’s assets (including any tax shields) just after the debt is issued, but before the shares are repurchased?
c. What is Kurz’s share price just before the share repurchase? How many shares will Kurz repurchase?
d. What are Kurz’s market value balance sheet and share price after the share repurchase?
A. Assets = Equity = $12 × 10 million shares = $120 million
B. Assets = 120 (existing) + 50 (cash) + 40% × 50 (tax shield) = $190 million
C. Equity = Assets – Debt = 190 – 50 = $140 million. Share price =14010=$14
Kurz will repurchase $50 million$14 = 3.571 million shares
D. Assets = 120 (existing) + 40% * 50 (tax shield) = $140 million
Debt = $50 million
E = A – D = 140 – 50 = $90 million
Share price=$90 million10 million-3.571 million=$14/share
Gladstone Corporation is about to launch a new product. Depending on the success of the new product, Gladstone may have one of four values next year: $110 million, $80 million, $75 million, and $40 million. These outcomes are all equally likely, and this risk is diversifiable. Suppose the risk-free interest rate is 2.5% and that, in the event of default, 25% of the value of Gladstone’s assets will be lost to bankruptcy costs. (Ignore all other market imperfections, such as taxes.)
a. What is the initial value of Gladstone’s equity without leverage?
Now suppose Gladstone has zero-coupon debt with a $75 million face value due next year.
b. What is the initial value of Gladstone’s debt?
c. What is the yield-to-maturity of the debt? What is its expected return?
d. What is the initial value of Gladstone’s equity? What is Gladstone’s total value with leverage?
Suppose Gladstone has 10 million shares outstanding and no debt at the start of the year.
e. If Gladstone does not issue debt, what is its share price?
f. If Gladstone issues debt of $75 million due next year and uses the proceeds to repurchase shares, what will its share price be? Why does your answer differ from that in part (e)?
a. Multiply the value of each outcome by its probability and discount it at the risk-free rate.
25% chance × 110+80+75+401.025=$74.39 million
b. Multiply payoff to debtholders by its probability and discount, as above.
0.25 × 75+75+75+40 ×(1- 0.25)1.025=$62.195 million
c. Yield to maturity can be found by comparing promised payments to its current market price. In other words, what is your return if you buy this bond and the bond issuer makes all promised payments.
Expected return = interest rate on the debt = 2.5%