F600 Winter 2016
Practice Set 4
Capital Structure
Problem 1
A company manufactures an item that it sells for $24.50 per unit. Variable costs are $16.50 per
unit, and total annual fixed costs are $700,000. In the fiscal year just completed, 880,000 units
were sold. The company has $14 million of 13 percent long-term debt outstanding, no preferred
shares, and 1.5 million common shares. The firm’s tax rate is 50 perfect.
a) Compute earnings before interest and taxes for the past year.
b) Calculate earnings per common share.
c) What is the degree of operating leverage based on the volume for the year just
completed?
d) What is the degree of financial leverage?
Problem 2
A firm that is financed solely through equity considers changing its capital structure to
introduce financial leverage. To achieve this, the firm would issue debt and use the proceeds to
repurchase some of its outstanding shares at their current market price of $50 per share. There
are currently 20,000 shares outstanding. EBIT of $300,000 per year are expected to remain
constant, and all net earnings are paid out in dividends. The firm can issue debt at an interest
rate of 12 percent, and the corporate tax rate is 40 percent. Three alternative amounts of debt
are under consideration, and the returns that shareholders demand in each case to compensate
for the added financial risk are given as follows:
Amount of debt 0 $200,000 $400,000
Required return on equity 18% 20% 25%
a) What is the optimal amount of debt to take on?
b) Show that, at the optimal capital structure, the firm simultaneously minimizes the
WACC and maximizes both the total value of the firm and the price of the outstanding
shares.
c) The required return for the unlevered firm drops to 16 percent. How would the required
return on equity have to increase for the various amounts of debt under consideration if
the WAAC is to remain constant regardless of leverage?
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Dividend Policy
Problem 1
A firm’s 500,000 common shares have a market value of $36 per share. All earnings have been
paid out in dividends, which have been constant at $3.60 per year. The company considers
retaining the next two years’ dividends to finance an expansion that would yield a perpetual
after-tax return of $450,000 per year, beginning in year three. How would this affect the share
price, assuming all subsequent earnings are again paid out in dividends?
What is the minimum yield the investment would have to provide in order to maintain the
present share price of $36?
Problem 2
A business has earnings of $10 million per year. It has 1.5 million shares outstanding, which
trade at a price-earnings multiple of 12. Up until now, the company has always paid out all of
its earnings as dividends. It is now considering skipping the dividend due at the end of this year
and instead using earnings to repurchase stock.
a) What is the total market value of the company?
b) If the same price-earnings multiple is applied to the firm, what will be the new price per
share? What will be the total market value of the company?
c) Assume that when the repurchase is announced, the market interprets this as a signal
that the firm’s shares are undervalued. Therefore, the firm’s price-earnings multiple
moves to 14. What will be the new price per share, and what will be the total market
value of the company?
share price
(Hint: PE Ratio = , thus share price (P*) = (P/E ratio)(EPS). In Part (a) find the MV of the
EPS
company before share repurchase. In part (b) you should account for share repurchase.)
Options
Problem 1
A call option has an exercise price of $10.00 and an expiry date in six months. The underlying
stock is currently trading for $12.00.
a) What is the minimum price an investor would pay for this option? Could an investor
profit if the call option was actually trading at $1.00?
b) What is the maximum price an investor would pay for this option? If the option was
trading for $13.00, how could an investor earn a risk-free profit?
Hint: this is more analytical question than quantitative
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Problem 2
A call option has a striking price of $8.10 and an expiry date six months hence. The underlying
stock is currently trading at $7.60 and has historically exhibited a standard deviation of 10.6
percent. The standard deviation is not expected to change. The interest rate is 5.4 percent.
Using the Black-Scholes equation, estimate the value of the call option described above. What
are some of the limitations of using the Black-Scholes equation?
Problem 3
Suppose that a stock currently trades for 50$ per share. In one year it may go up to $65 or down
to $40. Suppose that you can either buy or sell a call option on this stock with an exercise price
of $52.50. This is a European-style contract that expires in exactly one year. The risk free rate
of interest is 8% per year. Calculate the value of a one-year call option on this stock.
FUTURES
Problem 1
The spot exchange rate between Euros and U.S. dollars is US$0.86/Euro, while that between
Australian dollars and U.S. dollars is US$0.53/A$. The European one-year risk-free rate is 4
percent, while that in Australia is 10 percent. What is the one-year futures price of Australian
dollars in U.S. dollars if the one-year futures price of Euros is US$0.85/Euro?
Problem 2
The New York Stock Exchange Composite Index is at 638. The risk-free rate for one-year
investments in U.S. dollars is 6 percent, and the dividend yield on the portfolio of stocks that
makes up the index if 3.5 percent. The multiplier is 500, and a position limit of 5,000 contracts
is in place.
a) What should be the one-year futures price of the NYSE Composite Index?
b) Suppose the price of an important stock falls dragging down the index to 630. What
arbitrage profit can be earned by program trading if the futures price remains at the
value calculated in (a)?
c) Suppose the price of an important stock rises pulling the value of the index up to 646.
What arbitrage profits can be earned if the futures price remains at the value in (a)?
