BEA343: Corporate Finance - The Development of Capital Structure Theory - Accounting and Finance Assignment Help

Assignment Task:

Question 1:

Define capital structure, and discuss the development of capital structure theory (e.g. Miller and Modigliani Theorem).  

Question 2: 

The Ronald Co Ltd (RCL) is contemplating a $40 million national duplication of its replica division. It has forecast after-tax cash flows for the project of $10 million per year in perpetuity. The average yield to maturity of RCL’s is 8 per cent, and its cost of equity capital is 15 per cent. The tax rate is 30 per cent. Harry Lehman, the company’s chief financial officer, has come up with two financial options:

1. A $20 million issue of 10-year debt at 8 per cent interest. The issue costs would be 1 per cent of the amount raised. 

2. A $20 million issue of ordinary shares. The issue costs would be 12 per cent of the amount raised.

The target debt/equity ratio of RCL is 1. The expansion project will have the same risk as the existing business.   

1. What is the NPV of the new project at the target debt/equity ratio?  

2. Mr. Lehman has advised the company to go ahead with the new project and to utilise the debt option because debt is cheaper, and the issue cost will be less than shares. Is Mr. Lehman correct? Explain.  

Question 3:

Tasman Co. has a beta of 0.9, and an expected return of 15%. Macquarie Co. has a beta of 1.2 and an expected return of 16%. Lucy plans to invest in both stocks.

1. If risk-free rate is 2.5%, and Lucy are spreading her money equally on both stocks, what is the expected return on Lucy’s portfolio? 

2. If a portfolio of the two assets has a beta of 0.85, what are the portfolio weights?

3. If Lucy include one more risk-free asset into her existing portfolio in part (b), and this new portfolio has a beta of 1.3. what are the portfolio weights? How do we interpret the weight for the risk-free asset?

Question 4:

Company A and Company B are identical firms in every way except for their capital structure (Company B uses perpetual debt). 

The EBIT for both companies is expected to be $20 million forever. The shares of Company A are worth $100 million, and the shares of Company B are worth $50 million. The interest rate is 5 per cent. Michael owns $2 million of Company A’s shares. Please answer the following questions, ignoring taxes. 

1. What is rate of return for Company A? Show how Michael could generate the same cash flow and rate of return by investing in company B and using home-made leverage. 

What is the cost of capital for both companies? What principle does your answer illustrate? 

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