Problem Set 3
1. Bermuda
In Bermuda there are no corporate income taxes. Consider two Bermuda firms with
perfectly correlated future cash flows. The first is Debt Galore and the second is Debt
Zero. Each company is expected to generate $35m (before interest) in perpetuity. All
these cash flows are distributed as interest or dividends.
- Debt Galore has 150,000 risk-free bonds outstanding, each selling at a price of
$1,000. The interest on this debt is 7%. It has 1.5 million shares priced at $115
per share.
- Debt Zero has no debt. It has 3.6 million shares priced at $86 per share.
Capital markets are perfect and there are no transaction costs.
a. What is the implied discount rate for the future cash flows of the two firms? Is
there an arbitrage opportunity?
b. Construct a zero-risk, zero-investment strategy that generates an instantaneous
profit of $1m today. Compute the number of securities that are involved in the
transactions. What are the expected cash flows generated by the strategy one year
from now?
c. What is the outcome that you would expect if you were to repeat this strategy
indefinitely?
2. Freeride
Freeride is currently all-equity financed and has 10 million shares outstanding. Analysts
expect that the company will generate EBIT of €1.2m in perpetuity, starting next year.
The firm distributes all earnings as dividends. Assume that the CAPM assumptions hold,
the asset beta is 1.5, the risk-free rate is 3%, the market risk premium is 6%, and there are
no taxes.
a. Work out the market value balance sheet of Freeride.
Now assume that Freeride issues €1m of risk-free debt today and uses the proceeds at
once to pay an extraordinary dividend.
b. Work out Freeride’s market value balance sheet and stock price immediately after
the payment of the extraordinary dividend.
c. Compute the new return that shareholders expect after this set of transactions.
d. How would your answers to b. and c. change if the company uses the proceeds
from the debt issuance to repurchase shares instead?
Finance II – Católica Lisbon School of Business and Economics
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3. New Gears
New Gears Inc. expects to generate perpetual free cash flows of €10m per year, starting
next year. New Gears’ unlevered cost of capital is 10% and there are 10 million shares
outstanding. New Gears currently has €30m of risk-free debt. Assume perfect markets
and that the risk-free rate is 5%.
a. Assume that the company wants to move to a debt-to-value ratio of 40% and uses
the proceeds to repurchase stock. Compute the share price and shareholders’
opportunity cost of capital after this restructuring.
b. Assume instead that the company wants to decrease its debt so that its debt-to-
value ratio becomes 10%. The company will pay back the amount of debt needed
to achieve that target ratio using the proceeds of a new equity issuance. How many
shares does the firm need to issue (at fair value)?
c. Assume instead that the company decides to issue €14m worth of new equity at a
share price of €5.60 today in order to pay a special dividend to its existing
shareholders (new equity is issued at the ex-dividend price, but before the
payment date). Compute the change in the wealth of existing shareholders.
d. Assume that New Gears found out a positive-NPV investment opportunity in a
different business sector. If New Gears needs to issue €10m of new debt to finance
the new project, will the market value of its assets be less than, equal to, or greater
than €100m?
4. Yerba Industries
Yerba Industries is an all-equity firm, the stock of which has a beta of 1.2 and an expected
return of 12.5%. Suppose Yerba issues new risk-free debt with a yield of 5% and uses the
proceeds to repurchase 40% of its outstanding shares. Assume perfect capital markets.
a. What is the beta of Yerba stock after the restructuring of the firm’s capital
structure (issuance of debt and repurchase of equity)?
b. What is the expected return of Yerba stock after the restructuring?
Suppose that prior to the restructuring, Yerba’s shareholders were expecting earnings per
share equal to £1.50 for the coming year. The forward P/E ratio (the ratio of the current
share price over the expected earnings for the next period) was equal to 14.
c. What is Yerba’s expected earnings per share after the restructuring? Does this
mean that shareholders are better off or worse off? Explain.
d. What is Yerba’s forward P/E ratio after the restructuring? How can the change in P/E
ratio be justified? Explain.
Finance II – Católica Lisbon School of Business and Economics
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