Assumptions

Timeline % CF
0 -$100,000.00
1 50% $130,000.00
1 50% $180,000.00
rf 10%
Wacc 20%
a) NPV of project
Cash flow at time 1 P(s)*CF + P(s)*CF $155,000.00
Pv Cash Flow time 1 CFt1/(1+wacc) $129,166.67
NPV Cf0-PvCf1 $29,166.67
b. Suppose that to raise the funds for the initial investment, the project is sold to investors as an
all-equity firm. The equity holders will receive the cash flows of the project in one year. How
much money can be raised in this way—that is, what is the initial market value of the
unlevered equity?
In all equity firm the MVE is equal to Pvcashflows
c. Suppose the initial $100,000 is instead raised by borrowing at the risk-free interest rate.
What are the cash flows of the levered equity, and what is its initial value according to MM?
Unlevered firm
Pvdebt $100,000.00 Time zero Time one
Fvdebt $110,000.00 Debt $0.00 Debt $0.00
Equity $129,166.67 Equity $155,000.00
Firm $129,166.67 Firm $155,000.00
Levered firm
Time zero Time one
Debt $100,000.00 Debt $110,000.00
Equity $29,166.67 Equity $45,000.00
Firm $129,166.67 Firm $155,000.00
Another way
Fcequity $45,000.00 (discount Fvdebt to each probability of CF)
14-2. You are an entrepreneur starting a biotechnology firm. If your research is successful, the
technology can be sold for $30 million. If your 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 in exchange for 50% of the unlevered equity in the firm.
Capex 2
50% of unlevered equity of firm
a. What is the total market value of the firm without leverage?
Total value = 2M/0,5=4M
b. Suppose you borrow $1 million. According to MM, what fraction of the firm’s equity will
you need to sell to raise the additional $1 million you need?
Time zero
Asset 4 Equity 4

Time zero
Asset 4 Equity 3
Debt 1
14-3. Acort Industries owns assets that will have an 80% probability of having a market value of $50
million in one year. There is a 20% chance that the assets will be worth only $20 million. The
current risk-free rate is 5%, and Acort’s assets have a cost of capital of 10%.
80% 50
20% 20
rf 5%
wacc 10%

a. If Acort is unlevered, what is the current market value of its equity?

Presente value of cash flows discount at wacc
CF1 44
Cftime0 40 Market value of equity

b. Suppose instead that Acort has debt with a face value of $20 million due in one year.
According to MM, what is the value of Acort’s equity in this case?
In MM unlevered firm current value of equity is equal to current value of cashflows
In MM value of firm doesnt change with debt Pvdebt 19.04762

Time 0 Time 1
Equity 20.95238 Equity 24 Ereturnequity(no leverage) 0.1
Debt 19.04762 Debt 20 Ereturnequity (leverage) 0.145455
Firm 40 Firm 44

d. What is the lowest possible realized return of Acort’s equity with and without leverage?
Assumptions
Timeline % CF
0
1 50% $450,000,000.00
1 50% $200,000,000.00
rf 5% Market value of assets $250,000,000.00
Wacc 10%

a. What is the expected return of WT stock without leverage? 30.00%

b. Suppose the risk-free interest rate is 5%. If WT borrows $100 million today at this rate and
uses the proceeds to pay an immediate cash dividend, what will be the market value of its
equity just after the dividend is paid, according to MM?
Debt 100 Unlevered Levered
Equity $250,000,000.00 $150,000,000.00
debt $0.00 $100,000,000.00
Firm $250,000,000.00 $250,000,000.00
c. What is the expected return of MM stock after the dividend is paid in part (b)?
Debt to be paid T1 $105,000,000.00
Cashflows T1 $220,000,000.00 46.667%
14-6. Suppose Alpha Industries and Omega Technology have identical assets that generate identical
cash flows. Alpha Industries is an all-equity firm, with 10 million shares outstanding that trade
for a price of $22 per share. Omega Technology has 20 million shares outstanding as well as debt
of $60 million
Alpha Equity 220 Omega
all equity Firm 220 Equity 160 20 millions shares
10 millions shares Debt 60 8 price of share
22 dolars share Firm 220
because have identical assets in MM value of firm are equals

b. Suppose Omega Technology stock currently trades for $11 per share. What arbitrage
opportunity is available? What assumptions are necessary to exploit this opportunity?
Cisoft is a highly profitable technology firm that currently has $5 billion in cash. The firm has
decided to use this cash to repurchase shares from investors, and it has already announced these
plans to investors. Currently, Cisoft is an all-equity firm with 5 billion shares outstanding. These
shares currently trade for $12 per share. Cisoft has issued no other securities except for stock
options given to its employees. The current market value of these options is $8 billion.
USD Bln
Cash 5,000,000,000.00 €
Shares 5,000,000,000.00 €
stock price 12.00 € Equity 60,000,000,000.00 €
a. What is the market value of Cisoft’s non-cash assets?
Non-cash assets = equity + options – cash
63,000,000,000.00 €
b. With perfect capital markets, what is the market value of Cisoft’s equity after the share
repurchase? What is the value per share?
Will repurchase 5bilions over 12each 416.6667
14-8. Schwartz Industry is an industrial company with 100 million shares outstanding and a market
capitalization (equity value) of $4 billion. It has $2 billion of debt outstanding. Management have
decided to delever the firm by issuing new equity to repay all outstanding debt.
100 millions shares 100 a. How many new shares must the firm issue?
equity value 4000 price of share 40
debt 2000 debt to be paid 2000
new shares 50

b. Suppose you are a shareholder holding 100 shares, and you disagree with this decision.
Assuming a perfect capital market, describe what you can do to undo the effect of this
decision.
You can undo the effect of the decision by borrowing to buy additional shares, in the same
proportion as the firm’s actions, thus relevering your own portfolio. In this case you should buy 50
new shares and borrow $2000.
Zetatron is an all-equity firm with 100 million shares outstanding, which are currently trading
for $7.50 per share. A month ago, Zetatron announced it will change its capital structure by
borrowing $100 million in short-term debt, borrowing $100 million in long-term debt, and
issuing $100 million of preferred stock. The $300 million raised by these issues, plus another $50
million in cash that Zetatron already has, will be used to repurchase existing shares of stock. The
transaction is scheduled to occur today. Assume perfect capital markets.
all equity issuing debt
shares 100 short term 100
price 7.5 long term 100
preferred 100
cash 50
a. What is the market value balance sheet for Zetatron
i. Before this transaction? 750 because we have 50 cash than non cash are 700
ii. After the new securities are issued but before the share repurchase?
Assets =cash+non cash
Liabilities = equity+debt+preferred stock
14-12. 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?
D/E ratio 0.5 re=ru+d/e*(ru-rd) 15%
rd 6%
runlevered 12%
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?
D/E ratio 1.5 re=ru+d/e*(ru-rd) 18%
rd 8%
runlevered 12%
14-13. 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%?
re 9.20%
D/V 13% 15% re=ru+d/e*(ru-rd)
rd 6% 9.68%
Important convert D/V to D/E

1000
8% 80
35% 28
 1000 1000
491.8247 11500
172.1386 4025
14-14. 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.
equity 200
debt 100
re 15%
rd 6%
a. Suppose GP issues $100 million of new stock to buy back the debt. What is the expected
return of the stock after this transaction?
re=ru+d/e*(ru-rd) ru = (re - rd)/(1 + d/e) + rd
re 15% 12%
rd 6%
D/E 0.5
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?
re=ru+d/e*(ru-rd) 18%
equity 150
debt 150
rd 6%
14-15. Hubbard Industries is an all-equity firm whose shares have an expected return of 10%. Hubbard
does a leveraged recapitalization, issuing debt and repurchasing stock, until its debt-equity ratio
is 0.60. Due to the increased risk, shareholders now expect a return of 13%. Assuming there are
no taxes and Hubbard’s debt is risk free, what is the interest rate on the debt?
all equity issuing debt
re 10% D/E 0.6 Calculate wacc
D/V 0.375 rd = (WACC - (E/V)re)/(D/V) 5%
E/V 0.625 rd = (re - ru)*e/d + ru 5%
re 13%
14-16. Hartford Mining has 50 million shares that are currently trading for $4 per share and $200
million worth of debt. The debt is risk free and has an interest rate of 5%, and the expected
return of Hartford stock is 11%. Suppose a mining strike causes the price of Hartford stock to
fall 25% to $3 per share. The value of the risk-free debt is unchanged. Assuming there are no
taxes and the risk (unlevered beta) of Hartford’s assets is unchanged, what happens to
Hartford’s equity cost of capital?
Shares 50 Ru=wacc 8.00%
Price 4 re=ru+d/e*(ru-rd) 12.00%
equity 200 new D/E 1.333333
Debt 200
rd 5%
re 11%
14-17. Mercer Corp. is an all equity firm with 10 million shares outstanding and $100 million worth of
debt outstanding. Its current share price is $75. Mercer’s equity cost of capital is 8.5%. Mercer
has just announced that it will issue $350 million worth of debt. It will use the proceeds from this
debt to pay off its existing debt, and use the remaining $250 million to pay an immediate
dividend. Assume perfect capital markets.
a. Estimate Mercer’s share price just after the recapitalization is announced, but before the
transaction occurs.

all equity 750 No change in share price because there is no PVTS

Debt 100
re 8.50%
b. Estimate Mercer’s share price at the conclusion of the transaction. (Hint: use the market
value balance sheet.)
Initial EV 850
New debt 350
Equity 500 50
c. Suppose Mercer’s existing debt was risk-free with a 4.25% expected return, and its new debt
is risky with a 5% expected return. Estimate Mercer’s equity cost of capital after the
transaction.
rdold 4.25% re? re=ru+d/e*(ru-rd) Wacc
rdnew 5.00% ru?
In June 2009, Apple Computer had no debt, total equity capitalization of $128 billion, and a
(equity) beta of 1.7 (as reported on Google Finance). Included in Apple’s assets was $25 billion in
cash and risk-free securities. Assume that the risk-free rate of interest is 5% and the market risk
premium is 4%.

a. What is Apple’s enterprise value?

EV=Equity-Cash 103

b. What is the beta of Apple’s business assets?

Bu=E/(E+D)*BE 2.112621

c. What is Apple’s WACC?

rwacc=rf+Beta(Erm-rf)