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Question 1 a. Kappa is an all-equity firm. It has 120,000 sharesoutstanding, currently worth £20 per share. The unlevered cost ofequity is 20%. The firm has decided to issue £1,000,000 of 8% debt,and to use the proceeds to repurchase shares. Assume a 28%corporate tax rate.

i. According to Modigliani-Miller Proposition I with corporatetaxes, what is the market value of the firm’s equity after therepurchase? (6 marks)

ii. What are the firm’s earnings before interest and taxes?(Assume that earnings are cash flows.) (6 marks)

iii. What is the return on equity after the change in the firm’scapital structure? (7 marks)

iv. What is the value of a share after the capital structurechange? (10 marks)

AND b. Discuss the factors favoring a high-dividend policy. (12marks)

AND c. Stock A has an expected return of 5% and a standarddeviation of 10%. Stock B has an expected return of 10% and astandard deviation of 20%. The covariance between the returns ofthe two stocks is 0.001. Suppose an investor holds a portfolioconsisting of only stock A and stock B. Find the portfolio weights,XA and XB, such that the variance of her portfolio is minimized. (9marks)

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Keith Leannon
Keith LeannonLv2
28 Sep 2019

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Problem 14-21

Yerba Industries is an all-equity firm whose stock has a beta of 1.2 and an expected return of 12.5%. Suppose it issues new risk-free debt with a 5% yield and repurchases 40% of its stock. Assume perfect capital markets.
a. What is the beta of Yerba stock after this transaction?
b. What is the expected return of Yerba stock after this transaction?
Suppose that prior to this transaction, Yerba expected earnings per share this coming year of $1.50, with a forward P/E ratio (that is, the share price divided by the expected earnings for the coming year) of 14.
c. What is Yerba’s expected earnings per share after this transaction? Does this change benefit shareholders? Explain.
d. What is Yerba’s forward P/E ratio after this transaction? Does the P/E ratio go up or down?

Unlevered beta 1.20
Expected return 12.50%
Risk-free rate 5.00%
New debt level 40.00%

New Debt/Equity:
Market risk premium:

a. What is the beta of Yerba stock after this transaction?

New beta:

b. What is the expected return of Yerba stock after this transaction?

New expected return on equity:

Suppose that prior to this transaction, Yerba expected earnings per share this coming year of $1.50, with a forward P/E ratio (that is, the share price divided by the expected earnings for the coming year) of 14.
c. What is Yerba’s expected earnings per share after this transaction? Does this change benefit shareholders? Explain.

Old EPS $1.50
Forward P/E 14
Assumed shares 100

Price per share:
Old equity:
New debt:
New earnings:
New equity:
New shares:
New EPS:

d. What is Yerba’s forward P/E ratio after this transaction? Does the P/E ratio go up or down?

New P/E:
Price/Earnings ratio:

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