a) Gypco Inc. has decided in favour of a capital structuring that involves increasing its existing $80 million in debt to $125 million. The interest rate on debt is 9% and is not expected to change. The firm currently has 10 million shares outstanding and the price per share is $45. If the restructuring is expected to increase the ROE, what is the minimum level of EBIT that Gypco’s management must be expecting. Ignore taxes in your answer.
b) In each of the theories of capital structure the cost of equity rises as the amount of debt increases. So why don’t financial managers use as little debt as possible to keep the cost of equity down? After all, isn’t the goal of the firm to maximize share value and minimize shareholder costs?
c) Everystate Inc. is evaluating an extra dividend versus a share repurchase. In either case, $9,000 would be spent. Current earnings are $1.30 per share and the stock currently sells for $64 per share. There are 1,000 shares outstanding. In answering the questions that follow, ignore taxes for the first two:
i) Evaluate the two choices in terms of their effect on the price per share of stock and shareholder wealth.
ii) What will be the effect on Everystate’s EPS and P/E ratio under the two different scenarios?
iii) In the real world, which of these choices will you recommend? Why?
d) Consider a firm that can either pay out dividends of $10,000 per year for each of the next two years or can pay $9000 this year, reinvest the other $1000 into the firm and then pay $11,000 next year. Investors require a 12% return. Will the investors be indifferent between the two dividend policy choices? Explain your reasoning with the help of calculations.
e) Let RHC be the nominal interest rate in the home country and RFC be the nominal interest rate in the foreign country. S0 is the spot rate and F1 is the forward rate one period ahead. Covered interest arbitrage is not possible if interest rate parity holds. Using this knowledge and the notations given in the question, derive an expression for interest rate parity.