1 Consider two firms, With and Without, that have identical assets that generate

Question

1

Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%. There is no corporate tax.

Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as with. You have $5000 of your own money to invest and you plan on buying Without stock. Using homemade leverage you borrow enough in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5000 investment in with stock. The number of shares of Without stock you purchased is closest to:

A425 B1650 C2000 D825

2

Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%. There is no tax.

Galt's asset beta (ie the beta of its operating assets) is closest to:

A1.1 B1.2 C1.3 D1.4

3

Taggart Transcontinental has a value of $500 million if it continues to operate, but has outstanding debt of $600 million. If Taggart declares bankruptcy, bankruptcy costs will equal $50 million, and the remaining $450 million will go to creditors. Instead of declaring bankruptcy, Taggart proposes to exchange the firm's debt for a fraction of its equity in a workout. The minimum fraction of the firm's equity that Taggart would need to offer to its creditors for the workout to be successful is closest to:

A50% B75% C83% D90%

Explanation / Answer

1. Under MM I, the total value of With and Without must be the same.
Value(Without) = 1,000,000 × $24 = $24 million
Value(levered equity) = value(With) - debt = $24 M - $12M = $12 M
Price per share =
So, the leverage ratio of with is 50% equity to 50% debt. To duplicate this in homemade leverage
we need to have equal proportions in out portfolio, this means we need 50% equity and 50% from
a margin loan. So $5000 is our equity we need to match it with $5000 in a margin loan. So the
total invested is $10,000/$6 per share = 1667 shares
So, the option B is correct.

2.

3. The Minimum Fraction = $450 million / $500 = 90%. so the option D is correct.

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