1)a) Assuming perfect capital markets: This follows MM1 , and there are no taxes.
Beta of equity is determined by multiplying the beta of unlevered firm with one plus debt equity.
After repurchase the amount of equity will be reduced by 40%,and thus equity will be 60%.40% repurchase is using debt, thus debt is 40%
· βL = Levered or Equity Beta
· D/E = Market value Debt to equity ratio
· βu = Unlevered or Asset Beta
Details about Yerba industries:
Expected return in the unlevered firm(=12.5%
New risk-free debt (=5%
Repurchase=40% of stock
On Substituting the variables in the above equation,
Therefore, beta of the stock after this transaction is 2
b) In perfect capital markets, the second proposition of Modigliani and Miller holds.
Cost of equity ( is increasing in the percentage of debt in the capital structure.
c)Expected earning per share in the coming year=$1.50
Forward P/E ratio=14
Market price per share=P/E ratio* expected earning per share
Amount of borrowing required per share=Market price per share *Percentage repurchased
So 40% of $21 or $8.1 is borrowed
And interest is 5% of 8.4 which is $0.42
Earning per share after interest = Current earnings per share-interest per share
Earnings per share after transaction=(Earnings per share after interest/Percentage of equity after repurchase)
There is no benefit in this, the stock price does not change, but the risk involved in the transaction is high for shareholders. This is because of interest payments to debtholders.
d)P/E ratio = (Market price per share/Earnings per share after this transaction)
The P/E ratio has fallen from level of 14 to 11.67.This has happened because of the increase in the risk of the transaction. This increase in risk reduced the expectation of the investors.
3) a. False. There may be required capital expenditures or working capital needs that drain firm’s cash flows.
b. False. Depreciation may also be large and this can offset the capital expenditure.
c. False. This can be true sometimes. Commitment to pay interest expenses is more than commitment to pay dividends.
d. False. When managers are not owners , they may need debt to be disciplined.
e. False. This is not always the case. Firms which are mature and run well can have high free cash flows.
4) a. Cost of Equity = Re = Rf + βe*ERP (1)
Plugging these values in (1) we get,
Cost of equity = 6.50% + 1.47 (5.5%) = 14.59%
Cost of Capital = E/(E + D)*Cost of Equity+ D/(E + D)*After tax cost of debt (2)
=14.59% (24.27/(24.27+ 2.8)) + 6.8% (1-0.4) (2.8/(24.27+2.8)) =13.50%
b. If Pfizer moves to a 30% debt ratio,
New debt/equity ratio = 30/70 = 42.86%
Unlevered Beta =
=1.47/(1+0.6*(2.8/24.27)) = 1.37
New Beta =
=1.37 (1+0.6*0.4286) = 1.72
New Cost of Equity using (1) = 6.5% + 1.72 (5.5%) = 15.96%
New Cost of Capital using (2)= 15.96% (0.7) + 8.5% (1-.4) (0.3) = 12.70%