Question

Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all-equity firm, has 14,500 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 $64,500, and its cost of debt is 8 percent. Each firm is expected to have earnings before interest of $74,500 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 8 percent per year.

  

a.	What is the value of Alpha Corporation? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

  

Value of Alpha

$

  

b.	What is the value of Beta Corporation? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

  

Value of Beta

$

  

c.	What is the market value of Beta Corporation’s equity? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

  

Market value of Beta's equity

$

  

d.	How much will it cost to purchase 25 percent of each firm’s equity? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.)

  

	Amount to invest
Alpha	$
Beta	$

  

e.	Assuming each firm meets its earnings estimates, what will be the dollar return to each position in part (d) over the next year? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.)

  

	Dollar return on investment
Alpha	$
Beta	$

Answer 1

a.value of alpha corporation is equal to the value of equity = no. of shares outstanding * value per share

=14,500 * 20

= $2,90,000

b. since, both the firms are identical in all respects, according to the modiglani miller model in the absence of any form of taxes, the value of an unlevered firm is equal to the value of a levered firm. The value of alpha is equal to the value of beta

= $2,90,000

c. the market value of beta's debt is $64,500

value of the company = value of equity + value of debt

or, $2,90,000 = value of equity + $64,500

value of equity = $2,25,500

d.equity of alpha = $2,90,000

20% of equity = $58,000

20% of equity of beta : $45,100.

D.Since alpha does not have to any interest the dollar return on investment =$14,900

20% 0f EBIT = 20% *74,500

beta has to pay interest on the outstanding debt so,return will be :

($74,500 - 0.08*64,500) *0.2 = $13868

THE PERSON OWNING 20% OF BETA CORPORATION WILL GET 20% OF WHAT IS LEFT AFTER PAYING FOR THE INTEREST EXPENSES ON DEBT.