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Solutions Guide:   Please reword the answers to essay type parts so as to guarantee that your answer is an original. Do not submit as is

1. Executive Chalk is financed solely by common stock and has outstanding market price of $10 a share. It now announce that it intends to issue $160 million of debt and to use the proceeds to buy back common stock.

a.     How is the market price of the stock affected by the announcement?

b.     How many shares can the Company buy back with $160 million of new debt that it issues?

c.     What is the market value of the firm (equity plus debt) after the change in capital structure?

d.     What is the debt ratio after the change in structure?

e.     Who (if anyone) again or loses?

a. The market price of the stock is not affected by the announcement.

b. Since the market price of the shares is $10, the company can buy back:

$160 million/$10 = 16 million shares

c. After the change in capital structure, the market value of the firm is unchanged:

Equity + Debt = (9 million ( $10) + $160 million = $250 million

d. After the change in structure, the debt ratio is:

Debt/(Debt + Equity) = $160 million/$250 million = 0.64

e. No one gains or loses.

2. Omega Corporation has 10 million shares outstanding, now trading a $55 per share. The firm has estimated the expected rate of return to shareholders at about 12 percent. It has also issued long-term bonds at an interest rate of 7 percent. It pays tax at a marginal rate of 35 percent.

a.     What is Omega's after-tax WACC?

b.     How much higher would WACC be Omega used no debt at all? Hint: for this problem you can assume that the firm's overall beta(Beta A) is not affected by its capital structure or taxes saved because debt interest is tax-deductible.

Assuming that $200 million of long-term bonds have been issued.]

a. E = $55 ( 10 million = $550 million

V = D + E = $200 million + $550 million = $750 million

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After-tax WACC = [pic]

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b. As indicated in Table 17.4 in the text, the after-tax WACC would increase to the extent of the loss of the tax deductibility of the interest on debt. Therefore, the after-tax WACC would equal the opportunity cost of capital, computed from the WACC formula without the tax-deductibility of interest:

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People often convey the idea behind MM”s proposition 1 by various Supermarket analogies, for example, “ the value of a pie should not depend on how it is sliced”, or , “The cost of a whole chicken should equal the cost assembling one by buying tow drumsticks, two wings, two breads and so on”.

              Actually proposition 1 doesn't work in the Supermarket, You'll pay less for an uncut whole pie than for a pie assembled from pieces purchased separately. Supermarkets charge more for chickens after they are cut up, Why? What cost or imperfections likely to be important for corporations issuing securities on the U.S. or world capital market? Explain.

Some shoppers may want only the chicken drumstick. They could buy a whole chicken, cut it up, and sell off the other parts in the supermarket parking lot. This is costly. It is far more efficient for the store to cut up the chicken and sell the pieces separately. But this also has some cost, hence the observation that supermarkets charge more for chickens after they have been cut.

The same considerations affect financial products, but:

a. The proportionate costs to companies of repackaging the cash flow stream are generally small.

b. Investors can also repackage cash flows cheaply for themselves. In fact, specialist financial institutions can often do so more cheaply than the companies can do it themselves.

4. The Salad Oil Storage (SOS) Company has a large part of its facilities with long-term debt. There is a significant risk of default, but the company is not on the ropes yet Explain?

a. Why SOS stockholders could gain by investing in a positive –NVP project financed       by an equity issue.

b. Why SOS stockholders could gain by investing in a negative –NVP project financed by cash

c. Why SOS stockholders could gain from paying out a large cash dividend. How might the firm's adherence to a target debt ratio mitigate some or all of the problems noted

a. SOS stockholders could lose if they invest in the positive NPV project and then SOS becomes bankrupt. Under these conditions, the benefits of the project accrue to the bondholders.

b. If the new project is sufficiently risky, then, even though it has a negative NPV, it might increase stockholder wealth by more than the money invested. This is a result of the fact that, for a very risky investment, undertaken by a firm with a significant risk of default, stockholders benefit if a more favorable outcome is actually realized, while the cost of unfavorable outcomes is borne by bondholders.

c. Again, think of the extreme case: Suppose SOS pays out all of its assets as one lump-sum dividend. Stockholders get all of the assets, and the bondholders are left with nothing.

These conflicts of interest are severe only when the company is in financial distress. Adherence to a moderate target debt ratio limits the conflicts.

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