a) Rendezvous Ltd. expects its EBIT to be $100,000 every yearforever. The firm can borrow at 11 percent. Bruce currently hasno debt, and its cost of equity is 18 percent. The tax rate is31 percent. Bruce will borrow $61,000 and use the proceeds torepurchase shares. What will the WACC be after recapitalization?b) Provide at least two circumstances, where interest tax-shieldwill have no value for a company.c) Your firm has a debt-equity ratio of 0.60. Your cost of equityis 11 percent and your after-tax cost of debt is 7 percent. Whatwill your cost of equity be if the target capital structurebecomes a 50/50 mix of debt and equity?Question 2: 10 marksa) Everystate Inc. is evaluating an extra dividend versus a sharerepurchase. In either case, $9,000 would be spent. Currentearnings are $1.30 per share and the stock currently sells for$64 per share. There are 1,000 shares outstanding. In answeringthe questions that follow, ignore taxes for the first two:i) Evaluate the two choices in terms of their effect on theprice per share of stock and shareholder wealth3ii) What will be the effect on Everystate’s EPS and P/E ratiounder the two different scenarios?iii) In the real world, which of these choices will yourecommend? Why?b) At present, total dividends for each of the next two years areset equal to the cash flow of $10,000 per year. There are 100shares outstanding, so the dividend per share is $100. The priceper share at the moment is $173.55 and the required return ofinvestors is 10%. There is an alternative choice of paying$11,000 total dividends in the first year ($110 per share),followed by a liquidating dividend of $8,900 ($89 per share) inthe second. You prefer the first alternative but the firm’smanagement adopts the second alternative. You have 50 shares tobegin with and if you choose to create homemade dividends, howmany shares will you have at the end of the first year?4Question 3 (10 marks)a) Assume that you can buy 250 Canadian dollars with 100 Britishpounds and you have 100 British pounds. The following exchangerates are available.Country U.S. $ Equivalent Currency per U.S. $Canada ? 1.3500U.K. 1.8305 ? Complete the table above and compute how much profit, if atall, you can earn with triangle arbitrage?b) Assume the current spot rate is C$1.2103 and the one-year forwardrate is C$1.1925. The nominal risk-free rate in Canada is 3percent while it is 4 percent in the U.S.At what Canadian interest rate, there will be no possibility forprofitable arbitrage?
a) Rendezvous Ltd. expects its EBIT to be $100,000 every year
forever. The firm can borrow at 11 percent. Bruce currently has
no debt, and its
31 percent. Bruce will borrow $61,000 and use the proceeds to
repurchase shares. What will the WACC be after recapitalization?
b) Provide at least two circumstances, where interest tax-shield
will have no value for a company.
c) Your firm has a debt-equity ratio of 0.60. Your cost of equity
is 11 percent and your after-tax cost of debt is 7 percent. What
will your cost of equity be if the target capital structure
becomes a 50/50 mix of debt and equity?
Question 2: 10 marks
a) Everystate Inc. is evaluating an extra dividend versus a share
repurchase. In either case, $9,000 would be spent. Current
earnings are $1.30 per share and the stock currently sells for
$64 per share. There are 1,000 shares outstanding. In answering
the questions that follow, ignore taxes for the first two:
i) Evaluate the two choices in terms of their effect on the
price per share of stock and shareholder wealth
3
ii) What will be the effect on Everystate’s EPS and P/E ratio
under the two different scenarios?
iii) In the real world, which of these choices will you
recommend? Why?
b) At present, total dividends for each of the next two years are
set equal to the
shares outstanding, so the dividend per share is $100. The price
per share at the moment is $173.55 and the required return of
investors is 10%. There is an alternative choice of paying
$11,000 total dividends in the first year ($110 per share),
followed by a liquidating dividend of $8,900 ($89 per share) in
the second. You prefer the first alternative but the firm’s
management adopts the second alternative. You have 50 shares to
begin with and if you choose to create homemade dividends, how
many shares will you have at the end of the first year?
4
Question 3 (10 marks)
a) Assume that you can buy 250 Canadian dollars with 100 British
pounds and you have 100 British pounds. The following exchange
rates are available.
Country U.S. $ Equivalent Currency per U.S. $
Canada ? 1.3500
U.K. 1.8305 ?
Complete the table above and compute how much profit, if at
all, you can earn with triangle arbitrage?
b) Assume the current spot rate is C$1.2103 and the one-year forward
rate is C$1.1925. The nominal risk-free rate in Canada is 3
percent while it is 4 percent in the U.S.
At what Canadian interest rate, there will be no possibility for
profitable arbitrage?
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