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    Total market value of the firm with no growth opportunities

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    5.A consultant has collected the following information regarding Young Publishing

    Total assets $3,000 million
    Tax rate 40%
    Operating income (EBIT) $800 million
    Debt ratio 0%
    Interest expense $0 million
    WACC 10%
    Net income $480 million
    M/B ratio 1.00 #215
    Share price $32.00
    EPS = DPS =$3.20

    The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20 percent debt and 80 percent equity (based on market values) that the cost of equity will increase to 11 percent and that the pre-tax cost of debt will be 10 percent. If the company makes this change, what would be the total market value of the firm? (The answers are in millions.)

    a. $3,200

    b. $3,600

    c. $4,000

    d. $4,200

    e. $4,800

    7. Firms A & B are similar firms in the same industry. Firm A and B have the same profit margin and total asset turnover when compared. However, Firm A's capital structure is 50% debt and Firm B's capital structure is 66% debt. Which firm, given the above conditions will experience the highest return on equity (ROE) ?

    a. A

    b. B

    c. Can't tell from information given.

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    Solution Preview

    5. Current market value of equity = EBIT*(1-Tax Rate)/WACC = 800*(1-40%)/10%=$4800 million
    20% financed with debt, debt = 4800*20%=960 million

    Operating income (EBIT) = $800 million
    Interest expense = $960 million*10%=96 million
    EBT = ...

    Solution Summary

    Answers two multiple choice questions on equity valuation and return on equity.

    $2.19

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