M2Q9:

At the present time, Crimson plc is 100% equity financed and has a market value of $100,000. The company has an expected operating income of $20,000 (assume this is constant and is perpetual). The price of one share is $200 and there are no corporation taxes.

Assuming that capital markets are perfectly competitive and efficient and the capital asset pricing model holds at all times, we would like you to answer the following questions:

a. How many shares are in this unlevered company?

b. What is expected earnings per share?

c. What is the required (expected) rate of return on the shares?

d. What is the required rate of return on the assets of Crimson plc?

e. Suppose the company decides to lever and buys back $50,000 worth of shares with borrowed money which has a 10% rate of interest per annum.

How many shares are bought back and what is the present value of the debt?

f. What is the required (expected) rate of return on equity for Crimson plc now that it is levered?

g. If an investor bought one share in the unlevered company as described in (a), (b) and (c) and borrowed $200 to buy a further share (with an interest rate on the debt of 10%) ,

why the required return on this portfolio is the same as purchasing one share in the levered company (described in (e) and (f) above).

h. Using the weighted average cost of capital formula (WACC) calculate the required (expected) rate of return on the assets for the levered company described in (e) and (f) above.

i. Did leverage change the value of the real assets? Comment on your answer (a few sentences).