In Bermuda there are no corporate income taxes. Consider two Bermuda firms with perfectly correlated earnings. The first is Debt Galore and the second is Debt Zero. Each company is expected to earn $35 million (before interest) in perpetuity. All these earnings are distributed as interest or dividends. Debt Galore has $150 million of perpetual debt. The interest on this debt is 7 percent. It has 1. 5 million shares priced at $115 per share. Debt Zero has no debt. It has 3. 6 million shares at $86 per share.
Capital markets are perfect and there are no transaction costs. a. Is there an arbitrage opportunity? b. Construct a zero-risk, zero-investment portfolio with $1 million invested in the equity of Debt Zero that generates a positive income in perpetuity. 2. The Rastignac Corporation is financed with debt and equity. It has ? 300 million of equity and ? 40 million of risk free debt. The expected return on the equity is 10 percent and the risk-free return on the debt is 5 percent. Rastignac decides to issue another ?
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40 million of risk-free debt and to use the proceeds to repurchase equity. There are no taxes. a. What is the expected return on the equity of Rastignac after the refinancing? b. Jacques initially owns ? 100,000 worth of Rastignac’s equity, partly financed with a loan of ? 40,000 at the risk-free rate of 5 percent. This investment gave him the optimal combination of risk and return. How will he change his investment in Rastignac and the amount he borrows or lends after the refinancing? c.
After the refinancing, Rastignac unexpectedly announces an investment with a cost of ? 4 million and a NPV of ? 1 million. The project is financed with ? 2 million of cash on hand and ? 2 million of risk-free debt. Draw a market-value balance sheet showing the new value of Rastignac’s business and the market values of its debt and outstanding equity. 3. Schuldenfrei AG pays no taxes and is financed entirely by common stock. The stock has a beta of 0. 7, a price-earnings ratio of 10, and is priced to offer a 12 percent expected return.
Schuldenfrei now decides to repurchase half the common stock and substitute an equal amount of debt. If the debt yields a risk-free 6 percent, calculate: a. The beta of the common stock after the refinancing. b. The required return and risk premium on the stock after the refinancing. c. The required return for the company (stock and debt combined) after the refinancing. Assume that the operating profit of the firm is expected to remain constant in perpetuity. What is: d. The percentage increase in expected earnings per share?