Corporate Finance
Assignment no 1
Instructions:
1. Maximum weightage for this assignment is 5%.
2. This assignment is to be submitted individually.
3. Submissions without the names and roll numbers will not be graded.
4. Solve all the enclosed five questions and submit a hand written document. Soft copies and
submissions over email will not be considered.
5. Due date for submission: Dec 10 2024 5:00 pm.
6. You may submit your assignment to Ms. Lakshmi Priya (Academic Associate). She is available in
TA room Faculty Block B.
Assignment Questions
1. KMII Inc., a prominent consumer products firm, is debating whether or not to convert its all‐
equity capital structure to one that is 35 percent debt. Currently there are 5,000 shares outstanding
and the price per share is $49. EBIT is expected to remain at $43,600 per year forever. The interest
rate on new debt is 7 percent and there are no taxes.
a. Ms. Brown, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under
the current capital structure, assuming the firm has a dividend payout rate of 100 percent?
b. What will Ms. Brown's cash flow be under the proposed capital structure of the firm?
Assume that she keeps all 100 of her shares.
c. Suppose the company does convert, but Ms. Brown prefers the current all‐equity capital
structure. Show how she could unlever her shares of stock to recreate the original capital structure.
d. Using your answer to part (c), explain why the company's choice of capital structure is
irrelevant.
2. EMDT Co. and JBKH Co. are identical firms in all respects except for their capital structure.
EMDT is all equity financed with $540,000 in stock. JBKH uses both stock and perpetual debt; its
stock is worth $270,000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be
$61,000. Ignore taxes.
a. Richard owns $30,000 worth of JBKH's stock. What rate of return is he expecting
b. Show how Richard could generate exactly the same cash flows and rate of return investing in
EMDT and using homemade leverage.
c. What is the cost of equity for EMDT? What is it for JBKH?
d. What is the WACC for EMDT? For JBKH? What principle have you illustrated
3. Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures.
Each company expects to earn $18 million before interest per year in perpetuity, with each company
distributing all its earnings as dividends. Levered's perpetual debt has a market value of $65 million
and costs 8 percent per year. Levered has 1.9 million shares of stock outstanding that sell for $98 per
share. Unlevered has no debt and 3.8 million shares outstanding, currently worth $71 per share.
Neither firm pays taxes. Is Levered's stock a better buy than Unlevered's stock?
4. Delta Corporation and Theta Corporation are identical in every way except their capital
structures. Delta Corporation, an all‐equity firm, has 18,000 shares of stock outstanding, currently
worth $35 per share. Theta Corporation uses leverage in its capital structure. The market value of
Theta's debt is $85,000 and its cost of debt is 9 percent. Each firm is expected to have earnings
before interest of $93,000 in perpetuity. Neither firm pays taxes. Assume that every investor can
borrow at 9 percent per year.
a. What is the value of Delta Corporation?
b. What is the value of Theta Corporation?
c. What is the market value of Theta Corporation's equity?
d. How much will it cost 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 Delta's
equity and replicates both the cost and dollar return of purchasing 20 percent Theta 's equity
g. Is Delta's equity more or less risky than Theta's equity? Explain.
5. Homemade Leverage the Veblen Company and the Knight Company are identical in every
respect except that Veblen is unlevered. The market value of Knight Company's 6 percent bonds is
$1.6 million. Financial information for the two firms appears here. All earnings streams are
perpetuities. Neither firm pays taxes. Both firms distribute all earnings available to common
stockholders immediately.
Veblen Knight
Project operating income $610000 $610000
Year‐end interest on debt ‐ 96000
Market Value of stock 4400000 3550000
Market Value of debt ‐ 1600000
a. An investor who can borrow at 6 percent per year wishes to purchase 5 percent of Knight's
equity. Can he increase his dollar return by purchasing 5 percent of Veblen's equity if he borrows so
that the initial net costs of the two strategies are the same?
b. Given the two investment strategies in (a), which will investors choose? When will this
process cease?
