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Lecture 9 Capital Structure (2)
Example 1:
Alpha Corporation and Beta Corporation are identical
in every way except their capital structures. Alpha
Corporation, an all equity firm, has 5,000 shares of
stock outstanding, currently worth $20 per share.
Beta Corporation uses leverage in its capital structure.
The market value of Beta’s debt is $25,000. The cost
of this debt is 12 percent per annum.
Each firm is expected to have earnings before interest
of $350,000 in perpetuity. Neither firm pays taxes.
Assume that every investor can borrow at 12 percent
per annum.
A What is the value of Alpha Corporation?
B What is the value of Beta Corporation?
C What is the market value of Beta Corporation’s equity?
D How much will it cost to purchase 20 percent of each
firm’s equity?
E Assuming each firm meets its earnings estimates,
what will be the dollar return to each position in part
D over the next year?
F Construct an investment strategy in which an investor
purchases 20 percent of Alpha’s equity and replicates
both the cost and dollar return of purchasing 20
percent of Beta’s equity.
G Is Alpha’s equity more or less risky than Beta’s
equity? Explain.
Example (added): (Text 15.4):
The Veblen Company and the Knight Company are
identical in every respect except that Veblen is not
levered.
The market value of Knight Company’s 6 percent
bonds is $1 million. Financial information for the two
firms appears below.
All earnings streams are perpetuities. Neither firm
pays taxes. Both firms distribute all earnings
available to common stockholders immediately.
Veblen Knight
Projected operating $300,000 $300,000
income
Year-end interest on debt 60,000
Projected earnings $300,000 $240,000
available to common stock
Re
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