Alpha Corporation and Beta Corporation are identical in every way except their c
ID: 2750533 • Letter: A
Question
Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all equity firm, has 20,000 shares of stock outstanding, currently worth $25 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta’s debt is $70,000, and its cost of debt is 7 percent. Each firm is expected to have earnings before interest of $80,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 7 percent per year.
Assuming each firm meets its earnings estimates, what will be the dollar return to each position in part (d) over the next year? (Do not round intermediate calculations.)
Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all equity firm, has 20,000 shares of stock outstanding, currently worth $25 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta’s debt is $70,000, and its cost of debt is 7 percent. Each firm is expected to have earnings before interest of $80,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 7 percent per year.
Explanation / Answer
Answer:
(A). Value of Alpha:
= No.of Shares * Each Share Price
= 20,000 * $ 25
= $ 5,00,000
(B). Market Value of Beta Shares:
= Beta Shares Debt * Each Share Market Value
= 70,000 * $ 7
= 4,90,000
(C). Beta Corporation Equity:
Beta Corporation Equity = $ 70,000
(D).
Alpha: 5,00,000 * 25 / 100
= 1,25,000
Beta: 4,90,000 * 25 / 100
= 1,22,500
(E). Dollar Return on Investment Caluculation:
= Profit - Cost / Cost * 100
Alpha:
= $ 80,000 - 5,00,000 / 5,00,000 * 100
= 84%
Beta:
= $ 80,000 - 4,90,000 / 4,90,000 * 100
= 83.67 %
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