Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all-equity firm, has 19,000 shares of stock outstanding, currently worth $23 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta’s debt is $85,000, and its cost of debt is 7 percent. Each firm is expected to have earnings before interest of $71,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 7 percent per year.
a. What is the value of Alpha Corporation?
b. What is the value of Beta Corporation?
c. What is the market value of Beta Corporation’s equity?
d. How much will it cost to purchase 20 percent of each firm’s equity?
e. Assuming each firm meets its earnings estimates, what will be the dollar return to each purchase in part (d) over the next year?
f. Construct an investment strategy in which an investor purchases 20 percent of Alpha’s equity and replicates both the cost and dollar return of purchasing 20 percent of Beta’s equity.
g. Is Alpha’s equity more or less risky than Beta’s equity? Explain.