Task: Capital Structure in a Perfect Market
Question 1. You are an entrepreneur starting a biotechnology firm. If the research is successful, the technology can be sold for $30 million. If the research is unsuccessful, it will be worth nothing. To fund your research, you need to raise $2 million. Investors are willing to provide you with $2 million in initial capital to exchange for 50% of the unlevered equity in the firm.
a. What is the total market value of the firm without leverage?
b. Suppose you borrow $1 million. According to Modigliani and Miller (MM, what fraction of the firm’s equity will you need to sell to raise the XYZ has debt of $5000 on which it pays interest of 10% each year. Both companies have identical projects that generate free cash flows of $800 or $1000 each year. After paying any interest on debt, both companies use all remaining free cash flow to pay dividends each year.
Question 2. Fill in the table below showing the payments debt and equity holders of each firm will receive given each of the possible levels of free cash flow.
ABC XYZ_______
Debt Equity Debt Equity
FCF Payments Dividends Payments Dividends
$800
$1000
Question 3. Global Pistons (GP) has common stock with a market value of $200 million and debt with a value of $100 million. Investors expect a 15% return on the stock and a 6% return on the debt. Assume perfect capital markets.
a. Suppose instead GP issues $50 million new stock to buy back the debt. What is the expected return of the stock after this transaction?
b. Suppose instead GP issues $50 million of new debt to repurchase stock.
i. If the risk of the debt does not change, what is the expected return of the stock after this transaction?
ii. If the risk of the debt increases, would the expected return of the stock be higher or
lower than in part (i)?