Alpha Corporation and Beta Corporation are identical in every way
except their capital structures. Alpha Corporation, an all-equity
firm, has 5,000 shares of stock outstanding, currently worth $20 per
share. Beta Corporation uses leverage in its capital structure. The
market value of Beta?s debt is $25,000. The cost of this debt is 12
percent per annnum. Each firm is expected to have earnings before
interest of $350,000 in perpetuity. Neither firm pays taxes. Assume
that every investor can borrow at 12 percent per annum.
a. What is the value of Alpha Corporation?
b. What is the value of Beta Corporation?
c. What is the market value of Beta Corporation?s equity?
d. How much will it cost to purchase 20 percent of each firm?s equity?
e. Assuming each firm meets its earnings estimates, what will be the
dollar return to each position in part (d) over the next year?
f. Construct an investment strategy in which an investor purchases 20
percent of Alpha?s equity and replicates both the cost and dollar
return of purchasing 20 percent of Beta?s equity
g. Is Alpha?s equity more or less risky than Beta?s equity? Explain |
