EBK CORPORATE FINANCE
4th Edition
ISBN: 9780134202785
Author: DeMarzo
Publisher: VST
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Textbook Question
Chapter 21, Problem 9P
Hema Corp. is an all equity firm with a current market value of $1000 million (i.e., $1 billion), and will be worth $900 million or $1400 million in one year. The risk-free interest rate is 5%. Suppose Hema Corp. issues zero-coupon, one-year debt with a face value of $1050 million, and uses the proceeds to pay a special dividend to shareholders. Assuming perfect capital markets, use the binomial model to answer the following:
- a. What are the payoffs of the firm’s debt in one year?
- b. What is the value today of the debt today?
- c. What is the yield on the debt?
- d. Using Modigliani-Miller, what is the value of Hema’s equity before the dividend is paid? What is the value of equity just after the dividend is paid?
- e. Show that the ex-dividend value of Hema’s equity is consistent with the binomial model. What is the ∆ of the equity, when viewed as a call option on the firm’s assets?
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Hardmon Enterprises is currently an all-equity firm with an expected return of 18%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares. (Assume
perfect capital markets.)
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 5%. What will the expected return of equity be after this transaction?
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 7%.
What will the expected return of equity be in this case?
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?
a. Suppose Hardmon borrows to the point that its debt-equity ratio is 0.50. With this amount of debt, the debt cost…
A group of investors is intent on purchasing a publicly traded company and wants to estimate the highest price they can reasonably justify paying. The target company’s equity beta is 1.20 and its debt-to-firm value ratio, measured using market values, is 60 percent. The investors plan to improve the target’s cash flows and sell it for 12 times free cash flow in year five. Projected free cash flows and selling price are as follows.
($ millions)
Year
1
2
3
4
5
Free cash flows
$38
$53
$58
$63
$
63
Selling price
$
756
Total free cash flows
$38
$53
$58
$63
$
819
To finance the purchase, the investors have negotiated a $530 million, five-year loan at 8 percent interest to be repaid in five equal payments at the end of each year, plus interest on the declining balance. This will be the only interest-bearing debt outstanding after the acquisition.
Selected Additional Information
Tax rate
40
percent
Risk-free interest rate
3
percent
Market risk…
Chapter 21 Solutions
EBK CORPORATE FINANCE
Ch. 21.1 - What is the key assumption of the binomial option...Ch. 21.1 - Why dont we need to know the probabilities of the...Ch. 21.1 - Prob. 3CCCh. 21.2 - What are the inputs of the Black-Scholes option...Ch. 21.2 - What is the implied volatility of a stock?Ch. 21.2 - How does the delta of a call option change as the...Ch. 21.3 - What are risk-neutral probabilities? How can they...Ch. 21.3 - Does the binominal model or Black-Scholes model...Ch. 21.4 - Is the beta of a call greater or smaller than the...Ch. 21.4 - What is the leverage ratio of a call?
Ch. 21.5 - Prob. 1CCCh. 21.5 - The fact that equity is a call option on the firms...Ch. 21 - The current price of Estelle Corporation stock is...Ch. 21 - Using the information in Problem 1, use the...Ch. 21 - Suppose the option in Example 21.11 actually sold...Ch. 21 - Eagletrons current stock price is 10. Suppose that...Ch. 21 - What is the highest possible value for the delta...Ch. 21 - Hema Corp. is an all equity firm with a current...Ch. 21 - Consider the setting of Problem 9. Suppose that in...Ch. 21 - Roslin Robotics stock has a volatility of 30% and...Ch. 21 - Rebecca is interested in purchasing a European...Ch. 21 - Using the data in Table 21.1, compare the price on...Ch. 21 - Consider again the at-the-money call option on...Ch. 21 - Harbin Manufacturing has 10 million shares...Ch. 21 - Using the information on Harbin Manufacturing in...Ch. 21 - Using the information in Problem 1, calculate the...Ch. 21 - Prob. 23PCh. 21 - Prob. 24PCh. 21 - Calculate the beta of the January 2010 9 call...Ch. 21 - Consider the March 2010 5 put option on JetBlue...
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