Value of L = V L = VL = VU =$48,000,000 (ii) Owning 1% of firm U provides a dollar return of.01 [EBIT(1-T C )] =.01 x 6,000,000 = $60,000.

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1 OLUTION 1. A company wll call a bond when the market prce of the bond s at or above the call prce. For a zero-coupon bond, ths wll never happen because the market prce wll always be below the face value. For the coupon bond, there s some probablty that the bond wll be called. The company s opton to call s meanngless for the zero-coupon bond but has some value for the coupon bond. Therefore the yeld on the coupon bond wll be hgher. 2. () False. Accordng to MM Proposton II, the ncrease n leverage ncreases the expected return on the stock. Ths ncrease n expected return on equty s exactly offset by the ncrease n k n the equty due to the hgher debt. Hence, the prce of the stock s nvarant to leverage. () False. y wrtng bond covenants, bondholde can mnmze (not elmnate) agency costs assocated wth the conflct between stockholde and bondholde. ond covenants do mpose some real costs to frms because they reduce ther flexblty. For example, covenants mght prevent frms from takng good projects (f the covenants restrct nvestment polcy), repurchasng stock, or takng fresh debt for new projects. 3. EIT( 1 T ) 10, 000( 6 ) () alue of U = U = = = $40,000 r0. 15 alue of L = L = L = U + T = 40, * 20, 000 = =$4,000 () Ownng 1% of frm U provdes a dollar return of.01 [EIT(1-T )] =.01 x 6,000 = $60,00 Note that ths nvestment costs 1% of U s value of $43 mllon, whch s $430,00 Now suppose the nvestor purchases 1% of L s equty. Ths costs.01( L L ) =.01(49,000 20,000)=$290,00 The equty nvestment n L provdes a dollar return of:.01 (EIT-r L )(1-T ) =.01[10, (20,000)](.6) = $50,40 Ths leaves a shortfall of $9,600 (60,000-50,400). Ths can be made up by nterest receved on an nvestment n L s debt. nce there s no peonal taxes, $9,600 of nterest must be receved. Ths means that 9,600/.0 = $120,000 of L s debt should be purchased. The total cost of ths alternatve strategy s $290,000+$120,000 = $410,00 ummarzng: ost Dollar Return Orgnal trategy 1% of U s equty $430,000 $60,000 Alternatve trategy 1% of L s equty $290,000 $50,400 $120,000 of L s debt $120,000 $9,600 Total $410,000 $60,000 4

2 4. () r0 = E(R ) = R F + β[e(r M ) R F] r0 = E(R ) = ( )=.125 = 12.5% () / = 1 = r0 + (r0 r ) = ( ) =.20 = 20% 5. () E( R ) = r + β [ E( R ) r ] f r E( R ) = (.06)=.15 = 15% 0 = M f () U = E( EIT ) = r 0 3, 000* 60 =$12, () L = U + T = 12, *,000 = $15,200,000 = $,000 and = $7,200,000 = r0 + ( 1 T r ) = = [ ] ( )( ) WA = + = + = (v) r r ( 1 T )r ( 17) ( 6)( 12) 114 (v) = T = 12, *,000 = $15,200,000 (v) alue of Debt Tax held Expected value of bankruptcy costs (bankruptcy cost * prob) Net enefts of debt 2,500,000 1,000 0 $1,000 5,000 2, ,000 $1,360,000 5

3 7,500,000 3,000 1,760,000 $1,240,000,000 3,200,000 2,400,000 $00,000 The benefts of debt are maxmzed at a level of $5,00 (v) = T = 12, ,360,000 = $13,360,000 (v) If the frm has accumulated huge net losses, t cannot use the nterest tax shelds. Hence, the mplct corporate tax rate T s zero. = T = 12, = $12,000 r = $,000 and = $4,000 = r0 + [( 1 T r )] = 15 + ( 15 12) rwa = r + ( 1 T )r = = s = ( ) ( ) () = $750,000/.10 = $7,500,00 nce / =.3, = 7,500,000/.3 = $25,00 = + = $32,500,00 () efore the repurchase, 3, 750, , 000 r = =.12 25, 000 After the captal structure change, = r0 + ( r0 r ) = r0 + 5( r0 10 ) We know r but we don t know r 0. In a no tax scenaro, r0 = rwa = r + r + + We can use the captal structure before the change to calculate the r 0 snce we know r n that captal structure. / =.23; / =.77 r 0 = r WA =.23(.10) +.77(.12) =.1154 Hence n the new structure, r = (.5)( ) =.1231 There would be no effect on the stock prce when the repurchase s announced. () In ths scenaro, the stock prce wll ncrease snce the value of the frm wll ncrease by the present value of the nterest tax shelds. 6

4 7. The expected amount bondholde receve f cash flows fall short under bankruptcy s: $4 = [($100 *.5) + (X *.15)] / 1.1 => X = $49.34 Therefore, estmated bankruptcy costs must be $ $49.34 = $ a. alue of ts debt: $5M, snce dscount rate equals nterest rate. alue of unlevered equty: r 0 = 5% (10% - 5%) = 12.5% u = [1.5 (1 -.3)]/12.5% =.4 L =.4 + Tc = (5) = 9.9 b. ) New ond value = [5 (5%)]/% = 3.125m (It stll pays coupon rate of 5% but dscount rate s now %). L =.4 + Tc = (3.125) = ) ) No. ecause under MM-II wth corporate taxes only, debt ncreases value. Instead, t should take more debt. 1. Wth endoement = L = = = r0 + ( 1 T r ) = (1.3)( ) = rwa = r + ( 1 T ) r = (.176) + (1.3)(05) = = Wthout endoement = L = = = r0 + ( 1 T r ) = (1.3)(.125.0) = r WA = r + ( 1 T ) r = (.140) + (1.3)(0) = Increase: =

5 Method 2, whch s a lot easer: Use WA = EIT(1-Tc) / L (remember ths s the WA method n hapter 1) to fnd out WA pror and after the change. You get same results n 3 easy steps.. The goal s to help RIM rase money as cheaply as possble whle provdng an ncentve to nvesto to buy ts bonds. I would argue for the ssuance of convertble bonds. Ths would allow for a low coupon rate and would ensure that the value of the debt wll ncrease f the frm s dong well. It would provde an ncentve to the bondholde to gan from conveon to shares f the frm dd well. 9. a. Example: efore ssue, there are 100 shares at $10 each. The company sells 20 shares for cash at $5 each. ompany value must ncrease by 20 x 5 = $10 Thus, after ssue each share s worth: (100*10+100)/120 = $9.17. Note that new shareholde gan 20*(9.17-5) =$3.33. Old shareholde lose 100*( ) = $3.33. b. Example: efore ssue, there are 100 shares at $10 each. The company makes a rghts ssue of 20 shares at $5 each. Each rght s worth: (10 5)/6 = $3. The new share prce (ex-rght) s $9.17. If a shareholder sells hs rght, he or she receves $.3 cash and the value of the share he holds s $9.17. The shareholder s total wealth s unaffected by the rghts ssue. 1 a. An addtonal 2.5 mllon shares are ssued at a subscrpton prce of $4, so the total rased s $10 mllon. b. 10/2.5 = 4 rghts are requred to purchase one new share. c. M 0 The value of a rght = R0 = =$4 ( N + 1) d. The ex-rghts prce = Me = M 0 R 0 = 6-40 = $5.6 e. The share prce would have to fall below the subscrpton prce of $4.