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a. The rate of return earned will be the dividend yield.

The company has debt, so it


must make an interest payment. The net income for the company is:
NI = $9,!!! " .#!$$%!!,!!!&
NI = $,!!! ''9
The investor will receive dividends in proportion to the percenta(e of the company)s
shares they own. The total dividends received by the shareholder will be:
*ividends received = $,!!!$$'!,!!!+$%!!,!!!&
*ividends received = $%,#,
-o the return the shareholder e.pects is:
/ = $%,#,+$'!,!!!
/ = .#'0 or #'.01
b. To (enerate e.actly the same cash flows in the other company, the shareholder needs to
match the capital structure of 234. The shareholder should sell all shares in 567. This
will net $'!,!!!. The shareholder should then borrow $'!,!!!. This will create an
interest cash flow of:
Interest cash flow = .#!$"$'!,!!!&
Interest cash flow = "$',!!!
The investor should then use the proceeds of the stock sale and the loan to buy shares in
234.
The investor will receive dividends in proportion to the percenta(e of the company)s
share they own. The total dividends received by the shareholder will be:
*ividends received = $9,!!!$$8!,!!!+$9!!,!!!&
*ividends received = $0,#,
The total cash flow for the shareholder will be:
Total cash flow = $0,'!! " ',!!!
Total cash flow = $%,#,
The shareholders return in this case will be:
/ = $%,#,+$'!,!!!
/ = .#'0 or #'.01
c. 234 is an all e:uity company, so:
/; = /2 = $9,!!!+$9!!,!!!
/; = .##99 or ##.991
To find the cost of e:uity for 567, we need to use <=< >roposition II, so:
/; = /2 ? $/2 " /*& $*+;& $# " t4&
/; = .##99 ? $.##99 " .#!& $#&$#&
/; = .#'0 or #'.01'%!
d. To find the @244 for each company, we need to use the @244 e:uation:
@244 = $;+A&/; ? $*+A&/*$# " t4&
-o, for 234, the @244 is:
@244 = $#&$.##99& ? $!&$.#!&
@244 = .##99 or ##.991
2nd for 567, the @244 is:
@244 = $#+,&$.#'0& ? $#+,&$.#!&
@244 = .##99 or ##.991
@hen there are no corporate ta.es, the cost of capital for the firm is unaffected by the
capital structureB this is <=< >roposition I without ta.es.