a. Suppose there are no personal or corporate taxes and no transactions costs. The Playhouse Disney Company is entirely equity-financed, and has an annual EBIT of $900,000 (in perpetuity) and an equity capitalization rate of 10%. Another company, Treehouse, has $4,000,000 of 7.5% debt, an annual EBIT of $900,000 (in perpetuity) and an equity capitalization rate of 10%. Using the M&M propositions, demonstrate how to make a riskless profit without investing a penny of one’s own wealth.
b. Now in the same world without personal or corporate taxes and no transactions costs, assume a firm’s debt is risk-free, so that the cost of debt RD equals the risk-free rate Rf. Define βA as the firm’s asset beta – that is, the systematic risk of the firm’s assets. Define βE to be the beta of the firm’s equity. Use the CAPM along with M&M’s Proposition II to find the relationship between βA and βE.
c. G-20 is an all-equity firm which sells $100 pens and $100,000 tables to Harper Inc. G-20 earns an EBIT of $3.75 million this year which grows at 20% for the next 6 years, and then grows at 15% thereafter. The required rate of return on equity is 22%. Assuming no tax, what is the value of G-20? What is the WACC of G-20? If G-20 decides to use $50 million debt at 11% to retire equity, what will be the WACC? Now if the corporate tax rate is 40%, how much will be the addition to value due to the $50 million debt?
This question belongs to finance and discusses about Capital Structure of The Playhouse Disney and Treehouse Companies.
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