Problem:
A consultant has collected the following information regarding Young Publishing
Total assets $3,000 million
Tax rate 40%
Operating income (EBIT) $800 million
Debt ratio 0%
Interest expense $0 million
WACC 10%
Net income $480 million
M/B ratio 1.00 #215
Share price $32.00
EPS = DPS =$3.20
Q1. The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20 percent debt and 80 percent equity (based on market values) that the cost of equity will increase to 11 percent and that the pre-tax cost of debt will be 10 percent. If the company makes this change, what would be the total market value of the firm? (The answers are in millions.)
a. $3,200
b. $3,600
c. $4,000
d. $4,200
e. $4,800
Q2. Firms A & B are similar firms in the same industry. Firm A and B have the same profit margin and total asset turnover when compared. However, Firm A's capital structure is 50% debt and Firm B's capital structure is 66% debt. Which firm, given the above conditions will experience the highest return on equity (ROE) ?
a. A
b. B
c. Can't tell from information given.