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PROBLEM 14-11 BASED ON CHAPTER 14: WACC AND MODIGLIANI & MILLER EXTENSION MODELS WITH GROWTH ASSUMPTIONS

 

 

 

Consider the entrepreneur described in Section 14.1 (and referenced in Tables 14.1–14.3). Suppose she funds the project by borrowing $750 rather than $500.

 

 

 

TABLE 14.1 The Project Cash Flows

Date 0

Date 1

 

Strong Economy

Weak Economy

−$800

$1400

$900

 

 

 

TABLE 14.2 Cash Flows and Returns for Unlevered Equity

Date 0

Date 1: Cash Flows

Date 1: Returns

 

Initial Value

Strong Economy

Weak Economy

Strong Economy

Weak Economy

 

Unlevered equity

$1000

$1400

$900

40%

−10%

 

TABLE 14.3 Values and Cash Flows for Debt and Equity of the Levered Firm

 

Date 0

Date 1: Cash Flows

 

Initial Value

Strong Economy

Weak Economy

Debt

Levered equity

 $500

 E = ?

 $525

 $875

$525

$375

Firm

$1000

$1400

$900

 

 

a. According to MM Proposition I, what is the value of the equity? What are its cash flows if the economy is strong? What are its cash flows if the economy is weak?

 

b. What is the return of the equity in each case? What is its expected return?

 

c. What is the risk premium of equity in each case? What is the sensitivity of the levered equity return to systematic risk? How does its sensitivity compare to that of unlevered equity? How does its risk premium compare to that of unlevered equity?

 

d. What is the debt-equity ratio of the firm in this case?

 

e. What is the firm’s WACC in this case?

 

 

 

 

 

PROBLEM 14-18 BASED ON CHAPTER 14: WACC AND MODIGLIANI & MILLER EXTENSION MODELS WITH GROWTH ASSUMPTIONS

 

 

 

In mid-2012, AOL Inc. had $100 million in debt, total equity capitalization of $3.1 billion, and an equity beta of 0.90 (as reported on Yahoo! Finance). Included in AOL’s assets was $1.5 billion in cash and risk-free securities. Assume that the risk-free rate of interest is 3% and the market risk premium is 4%.

 

a. What is AOL’s enterprise value?

 

b. What is the beta of AOL’s business assets?

 

c. What is AOL’s WACC?

 

 

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