Paper Topic:

Managerial Finance

Question 1

a ) Acetates debt-equity ratio 10 million 20 million 1 :2

b

Market value of the firm (V D E

D : Market value of Debt

E : Market value of equity 20 10 30 33

E (re Rf ?e[Rm - Rf]

Re 8 0 .9 (18 -10 17

Cost of debt Rd 14 WACC 0 .33 (17 0 .66 (14 14 .85

c ) Cost of Capital of an identical all-equity firm Cost of equity 17

Question 2

A ) The value of a firm 's equity is the discounted

expected cash flow to the firm 's stockholders

Dietrich Corporation

The value of Dietrich Corporation equity is (0 .80 2 million (0 .20 0 .8 / 1 .15 1 .53 million

The value of Dietrich Corporation debt is 0

Steinberg Corporation

The value of Steinberg Corporation equity is

If expansion continues , Steinberg Corporation will generate cash flow of 2 million . Since it owes its bondholders 750 ,000 , the firm 's stockholders will receive 1 .25 million 2 million - 750 ,000

If there is a recession , Steinberg Corporation will generate a cash flow of 0 .8 million . Since it owes its bondholders 750 ,000 , the firm 's stockholders will receive 50 ,000

The probability of expansion is 80 . The probability of a recession is 20 . The appropriate discount rate is 15

Therefore the value of Steinberg Corporation equity is (0 .80 1 .25 million (0 .20 0 .05 / 1 .15 830 ,000

The value of Steinberg Corporation debt is

The market value of a firm 's debt is the discounted expected cash flow to the firm 's debt holders

Firm bondholders will receive 750 ,000 in a recession or expansion since the company generated enough income to cover its debt

The value of Steinberg Corporation debt is 750 ,000 / 1 .15 652 ,174

B ) The value of a firm is the sum of the market value of the firm 's debt and equity

Dietrich Corporation

The value of Dietrich Corporation equity is 1 .53 million

The value of Dietrich Corporation debt is 0

The value of Dietrich Corporation is 1 .53 0 1 .53 million

Steinberg Corporation

The value of Steinberg Corporation equity is 830 ,000

The value of Steinberg Corporation debt is 652 ,174

The value of Steinberg Corporation is : 830 ,000 652 ,000 1 ,482 ,000

c ) I disagree with Steinberg 's CEO as the value of a company does not change by changing the capital structure since changing the capital structure does not increase the value of the cash flows generated by its real assets and operations according to Modigliani and Miller Capital Structure Theory

Question 3

Financial leverage involves the use of debt finance . Financial leverage increases the amount of debt of a company in relation to its equity does not affect the risk of operating income and business risk of the firm The increased amount of debt increases the uncertainty about percentage of stock returns . This is because the amount of debt increase or decrease earnings per share . During a...

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