Question

Albo Corporation and Black Corporation are identical in every way except their capital structures. Albo Corporation, an all-equity firm, has 45 million shares of stock outstanding, currently worth $15 per share. Bluco Corporation uses leverage in its capital structure. The market value of Blco debt is $350mil., and its cost of debt is 4.5 percent. Each firm is expected to have earnings before interest and tax of $100mil. in perpetuity. Assume that every investor can borrow at 5 percent per year. Corporate tax rate is 40%.
Required:
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 15 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?

Answer 1

Answer:

Albo Corporation and Bluco Corporation

a. The value of Albo Corporation is: $675 million

b. The value of Bluco Corporation is: $675 million

c. The market value of Bluco Corporation is: $325 million

d. The cost of purchasing 15% of each firm's equity:

                                              Albo                         Bluco

Cost of 15% in equity     $101.25 million           $48.75 million

e.                                           Albo                          Bluco

Dollar return in (d)           $9 million                $8.595 million

Explanation:

a) Data and Calculations:

                                           Albo                    Bluco

Outstanding stock     45 million shares

Market price of stock      $15 per share

Total market value   $675 million (45 * 15)

Market value of debt        0                          $350 million

Total value                 $675 million               $675 million

Equity of Bluco                                              $325 million ($675 - 350)

Earnings before interest

  and tax                    $100 million               $100 million

Interest on debt (4.5%)       0                           $4.5 million

Earnings before tax  $100 million                 $95.5 million

Corporate tax (40%)   $40 million                   38.2 million

Earnings after tax      $60 million                 $57.3 million

Cost of 15% in equity $101.25 million           $48.75 million

Dollar return              $9 million                    $8.595 million

Dollar return = 15% of total earnings after tax