Tarun Singh

Worked with Richard Gong

Ec 1745 Problem Set 6
1. A) p0= (p10)/((1.10)^10)
B) rate of earnings growth for first 10 yrs: 15%
e10 = e1((1.15)9) → $69(1.15)9= $242.73
C) kt+1 = kt(1+λROE); λ=1 for years 1-10
$69 = k0(ROE) → k0 = $69/.15 = $460
k10 = k0(1+λROE)9 → k10 = $460(1.15)9 = $1618.22
D) e11 = ROE(k10) = .08($1618.22) = $129.46
E) D11 = (1-λ)e11 = (1-0)$129.46 = $129.46
Given that all the earnings are paid out the growth rate of the dividends
from year 11 onward are 0%.
F) p10 = D11/(r-g)= ($129.46)/(.1-0) = $1294.6
G) p0 = (p10)/((1.10)^10) = ($1294.6)/(1.110) = $499.12
2. A) P/E = (1-λ)/(r-λROE)
ΔROE = ((.7 + 50r -1)/(50(.7))) - ((.7 + 30r -1)/(30(.7)))
= -(1/75) – (1/35) + (1/21) = .00571429 = .05714%
B) r= ((1-λ)/(P/E)) + λROE
Δr = ((1-.7)/50)-((1-.7)/30) = -.004 = -.04%
C) 1) A firm with P/E = 30: ROE = ((.7+(.1(30))-1)/(.7(30))) = .1286
A firm with P/E = 50: ROE = ((.7+(.1(50))-1)/(.7(50))) = .13429
→ Avg ROE = .1314
New P/E = (1-λ)/(r-λROE) = (1-.7)/(.1-.7(.1314)) = 37.5
2) ROE1 = ((.7+(.1(20.5))-1)/(.7(20.5))) = .12195
ROE2 = ((.7+(.1(150))-1)/(.7(150))) = .14
→ Avg ROE = .130975
3) Due to convexity of P/E with respect to ROE, the greater the dispersion in
ROE across firms the higher the P/E ratio.
3. A) Convertible debt holders convert debt to equity if they can get more than
$500,000. By converting the total number of shares doubles to 20,000.

V= V=$1,000,0 V=$1,500,0 V=$2,000,0 V=$2,500,0

$500,000 00 00 00 0
Vs $500,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000
Vc $0 $0 $500,000 $500,000 $750,000
Ve $0 $0 $0 $500,000 $750,000
 C) If the company does poorly senior debt is impacted negatively, equity
holders are also impacted negatively but they cannot lose money. If the
company does well senior debt doesn’t get an additional pay-off whereas
equity holders do. Thus, equity holders want the company to take risky
projects with npv=0 but senior debt does not. For convertible debt if the
pay-off function is concave then convertible debt holders will prefer risk but
if it is convex they will not.
4. A) rate of return required by investors : .07+1.6(.17-.07) = .23 = 23%
.20<.23 ; so the excess rate of return is less than that predicted by CAPM so
this project is not acceptable.
Investor require a 3% excess rate of return above the return

B) WACC = wd(Rd) + (1-wd)(Re)

Re = Ra+(wd/(1-wd))(Ra-Rd)
Rd = .07+.4(.17-.07) = .11 ==11%
WACC = wd(Rd) + (1-wd)( Ra+(wd/(1-wd))(Ra-Rd)) = wd(Rd) +(1-wd)Re
→ WACC = Ra = .23 = 23%
According to Modigliani & Miller, WACC=E(Ra) in a frictionless world, meaning
there are no transaction costs, no corporate taxes, no differences of opinion
and no big players. This means that WACC is not dependent upon leverage.
Therefore, neither Alan nor Bruce is correct.

C) If corporate taxes are 30% then Bruce is right and the firm can lower the
cost of capital by using leverage, meaning it would be possible to make the
project viable.
WACC = .2 = wd(1-T)(Rd) + (1-wd)(Re) = wd(1-T)(Rd) + (1-wd)(Ra) + w(Ra-Rd)
→ WACC = .2 = Ra – wd(T)(Rd) → wd = ((.23 - .2)/((.3)(.11))) = .9091 =
90.91%
A debt of 90.91% would be required to make this project viable.

D) Bruce will still be correct because the personal tax rate on both dividends
and interest payments cancel each other out. Therefore the required weight
for debt will still be 90.91%.

E) If the personal tax applies only to interest payments then the tax on debt
is greater than the tax on equity, therefore there is no benefit to increasing
leverage. Thus, Alan would be correct in this case. Furthermore, because the
tax on debt is greater than the tax on equity this would mean that the firm
would not be able to profitably carry out this project.