Two firms, Alpha and Beta, are in the same business and size and identical in all respects except the way in which they have financed their assets. If the economy does well in the coming year, both firms would earn profit before interest and taxes (PBIT) of Rs. 150 million. The PBIT would be Rs. 50 million in slump economic condition. There is a 50% chance for each of the event. Alpha is fully equity funded and hence its investors would get either Rs. 150 million or Rs. 50 million depending on the economic conditions. Beta has borrowed Rs. 400 million at 10% and hence has a fixed interest liability of Rs. 40 million. Thus shareholder of Beta would get either Rs. 110 million or Rs. 10 million depending on the economic conditions. Both companies and their investors are not expected to pay any taxes. Equity investors of Alpha expect a minimum return of 20%.
Answer the following (Question (i) to (v) carry 2 marks each and Questions (vi) to (x) carry 5 marks each)
(i) What is the value of Equity of Alpha?
(ii) What is the value of Equity of Beta?
(iii) What is the value of Beta Company?
(iv) What is the cost of equity of Beta Company?
(v) What is the cost of capital of Beta Company?
(vi) Alpha company decides to raise Rs. 200 million by issuing 10% bond and use the funds to buy back the shares at the market price. What is the impact of this restructuring action to the shareholders of Alpha Company?
(vii) Alpha company decides to raise adequate funds through issue of bonds at 10% to buyout all equity shares of Beta Company at the prevailing market price and merge the Beta company with Alpha company after purchasing all the shares. What is the impact of this action on the value of equity of Alpha company? Assume there is no cost or strategic benefit from the merger.
(viii) Suppose the value of equity of Beta Company based on current market price is Rs. 300 million. If you are holding 20% stake of the company, what you will do to maximize your profit?
(ix) Suppose the value of equity of Alpha Company and Beta Company are Rs. 600 and Rs.100 respectively based on the market price. If you are holding 20% stake in Alpha Company, what you will do to maximize your profit?
(x) Suppose Alpha Company and Beta Company are paying a tax rate of 30%. What would be the value of the equity shares of Beta Company in the world of corporate tax?