financial management problems 6301

1. There are two identical firms EQT Corp and DBT Corp except for their capital structure. For example none of the firms pay taxes, and EBIT is $22,000 per year for both firms. There is no growth for any of the firms. EQT is an all equity firm with 1,000 shares outstanding and expected return of 22%. Since there is no growth, EQT will pay out all earnings to shareholders as dividends. In contrast, DBT has $40,000 worth of debt outstanding with interest rate of 5%. There are 500 shares of equity outstanding for DBT Corp. After the interest expense,
DBT will also pay out all the earnings to its shareholders.
(a) What are the equity values of both EQT Corp and DBT Corp? And, what are both companies’ stock prices?
(b) What is the expected return on equity of DBT? Which company is riskier and why?
(c) Suppose currently you own 212 shares of DBT stock and John owns 200 shares of EQT stock. What would you do if you want to have exactly the same total dividends as John’s? Assume you can borrow or lend at
5%.
2. Carlson Enterprise is financed entirely by common stock with a beta of 0.6. There are no taxes. The market expected return is 11%. The company decides to repurchase one fourth of its common stock and substitute with an equal value of debt. If the debt yields the same as the risk-free rate of 3%, calculate:
(a) the beta of the common stock after the refinancing
(b) the required return and risk premium on the common stock before and after the refinancing
(c) the required return on the company (i.e., stock and debt combined) after the refinancing
3. Backyard Utility is an all-equity firm, and is expected to have an EBIT of $250,000. EBIT is expected to grow at 6% per year. In order to get this growth rate, Backyard needs to retain 50% of earnings for investment. The remaining will be paid out as dividends. The firm’s corporate tax rate is 20%. The current discount rate for the firm is 10%.
(a) What is the market value of the firm?
(b) Now assume