Question

Ken Corporation and Ryu Corporation are identical in every way except their capital structure. Ken Corp is an all equity financed firm with 10,000 shares outstanding, currently worth $15 per share. Ryu Corp uses leverage in its capital structure and market value of Ryu Corp’s debt is $50,000, while its cost of debt is 8%. Both firms do not pay any taxes and are expected to have earnings before interest of $50,000 in perpetuity. Assume that every investor can borrow at 8% per year.

1. (a) (4 points) What is the value of Ken Corp?

2. (b) (3 points) What is the value of Ryu Corp? (Hint: Modigliani-Miller Theorem)

3. (c) (3 points) What is the value of Ryu Corp’s equity?

4. (d) (3points)Howmuchwoulditcosttobuy20%ofeachfirm’sequity?

5. (e) (4 points) Assuming that each firm meets its earnings estimate, what will be the return in dollars to

   each position in part (d) over the next year?

6. (f) (5 points) Construct an investment strategy (homemade leverage) in which an investor buys 20% of

   Ken’s equity but replicates both the cost and dollar return of buying 20% of Ryu’s equity. Explain how

   you can do this.

7. (g) (3 points) Is Ken Corp’s equity more or less risky than Ryu Corp’s equity?

Answer 1

Solution:

a)Value of Ken Corp

As per  Modigliani-Miller Theorem,the value of firm is correctly calculated as the present value of its future earning and is independent of its capital structure

Value of Ken Corp=Earning/Capitalisation rate

=$50,000/8%

=$625,000

b)In no tax environment,Value of levered firm is equal to value of unlevered firm.Accordingly value of Ryu Corp is equal to value of Ken Corp.Thus value of Ryu Corp is $625,000

c)Calculation of Ryu Corp's equity

Value of equity=Total value-value of debt

=$625,000-$50,000

=$575,000

d)Cost to buy20%of each firm’s equity

Since the market value of ecah firm is same that is $625,000,thus cost to buy 20% of equity will be also same.

Cost to buy=Market value*20%

=$625000*20%

=$125,000