CAPITAL STRUCTURE-Assignment
I. XYZ Inc., has no debt outstanding and a total market value of $150,000. Earnings before
interest and taxes [EBIT] are projected to be $14,000 if economic conditions are normal. If there
is a strong expansion in the economy, then EBIT will be 30% higher. If there is a recession, then
EBIT will be 60% lower. XYZ is considering a $60,000 debt issue with a 5% interest rate. The
proceeds will be used to repurchase shares of stock. There are currently 2,500 shares
outstanding. Under a perfect capital market, answer the following:
1. Under the current capital structure, what is the ROE, ROA and EPS under a normal, strong
and recession economy?
2. Under the proposed capital structure, what is the ROE, ROA and EPS under a normal, strong
and recession economy?
3. Assuming XYZ does not recapitalized, but an investor who wants to invests in 200 shares of
the company wants the leveraged capital structure, what should he do?
4. Assuming XYZ does recapitalized, but an investor with 200 shares of the company wants the
unlevered capital structure, what should he do?
II. Suppose Alpha Industries and Omega Technology have identical assets that generate identical
cash flows. Alpha Industries is an all-equity firm, with 10 million shares outstanding that trade
for a price of $22 per share. Omega Technology has 20 million shares outstanding as well as debt
of $60 million.
a. According to MM Proposition I, what is the stock price for Omega Technology?
b. Suppose Omega Technology stock currently trades for $11 per share. What arbitrage
opportunity is available? What assumptions are necessary to exploit this opportunity?
III. HardmonEnterprisesiscurrentlyanall-equityfirmwithanexpectedreturnof12%.Itiscon- sidering
a leveraged recapitalization in which it would borrow and repurchase existing shares.
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 6%. 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 8%. What will the expected return of equity be in this case?
c. Aseniormanagerarguesthatitisinthebestinterestoftheshareholderstochoosethecapital
structure that leads to the highest expected return for the stock. How would you respond to this
argument?