1.Indell stock has a current market value of $120 million and a beta of 1.50. Indell currently has risk-free debt as well. The firm decides to change its capital structure by issuing $30 million in additional risk-free debt, and then using this $30 million plus another $10 million in cash to repurchase stock. With perfect capital markets, what will be the beta of Indell stock after this transaction?
2.Consider the entrepreneur described in Section 14.1 (and referenced in Tables 14.1–14.3). Suppose she funds the project by borrowing $750 rather than $500.
a. According to MM Proposition I, what is the value of the equity? What are its cash flows if the economy is strong? What are its cash flows if the economy is weak?
b. What is the return of the equity in each case? What is its expected return?
c. What is the risk premium of equity in each case? What is the sensitivity of the levered equity return to systematic risk? How does its sensitivity compare to that of unlevered equity? How does its risk premium compare to that of unlevered equity?
d. What is the debt-equity ratio of the firm in this case?
e. What is the firm’s WACC in this case?
3.Hardmon Enterprises is currently an all-equity firm with an expected return of 12%. It is considering 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. 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?
4.Suppose Microsoft has no debt and an equity cost of capital of 9.2%. The average debt-to-value ratio for the software industry is 13%. What would its cost of equity be if it took on the average amount of debt for its industry at a cost of debt of 6%?