Question

Wolfrum Technology (WT) has no debt. Its assets will be worth $450 million in one year if the economy is strong, but only $200 million in one year if the economy is weak. Both events are equally likely. The market value today of its assets is $250 million.
a. What is the expected return of WT stock without leverage?
b. Suppose the risk-free interest rate is 5%. If WT borrows $100 million today at this rate and uses the proceeds to pay an immediate cash dividend, what will be the market value of its equity just after the dividend is paid, according to MM?
c. What is the expected return of WT stock after the dividend is paid in part (b)?

Answer 1

Answer:

Explanation:

Assets in a strong economy = 450m

Assets in a weak economy = $200m

Current market value of assets = $250m

Risk free interest rate = 5%

Workings

a)

Expected return without leverage

(average return in both types of economy)/ current market value

((450 + 200)/2)/250

650/2/250 = 1.3

Returns = 1.3-1= 30%

b)

Market value of the assets = 250

Debt = 100

Equity = Asset - debt = 250 -100 = 150

C)

Dividend paid  100

Interest = 5%

Book value = 100* 5%=105

= ((450-105) + (200-105))/2/ 150

(345+95)/2/150 =1.4667

Expected return = 1-1.4667*100

=46.67%