Question #03

a)

Two firm L(levered) and U (unlevered) are identical in every respect except that U is

all equity (unlevered) while L (Levered) has 5 million of 10 percent bonds

outstanding .The expected EBIT to both firms is 2 million and cost of equity for firm

U is 10 percent and for L is 12 percent. Assume the MM world for each firm:

a) What is value of each firm if MM assumptions hold?

b) Find out the implied overall capitalization rate?

c) If the value of two firms differs how does this disequilibrium will proceed to

equilibrium (arbitrage process)?

b)

Neilson Corporation has Rs.100, 000 debts at 10 percent interest and it's expected

annual operating Income is Rs. 1 million. The CFO of Neilson Corporation is worried

that investors are not placing the fair value on Neilson share. So he thinking about

share repurchases to increase the firm value. However to finance repurchase of stocks

Neilson has to issue more debt. He estimates the Rs.30, 000 more debt needs to issue

to get the required financing for repurchase. Neilson has overall capitalization is 15

percent.

a) What is value of firm before new issuance of debt and after it (Using Net

operating approach)?

b) What is implied cost of equity before and after issuance of debt?

c) What is share price before and after issuance of debt?

d) What results do you draw regarding cost of equity and share price after new

issuance of debt?