Equity Finance of The Disney Playhouse and Treehouse Company

Question

Capital Structure

a. Suppose there are no personal or corporate taxes and no transactions costs. The Playhouse Disney Company is entirely equity-financed, and has an annual EBIT of $900,000 (in perpetuity) and an equity capitalization rate of 10%. Another company, Treehouse, has $4,000,000 of 7.5% debt, an annual EBIT of $900,000 (in perpetuity) and an equity capitalization rate of 10%. Using the M&M propositions, demonstrate how to make a riskless profit without investing a penny of one’s own wealth.

b. Now in the same world without personal or corporate taxes and no transactions costs, assume a firm’s debt is risk-free, so that the cost of debt RD equals the risk-free rate Rf. Define βA as the firm’s asset beta – that is, the systematic risk of the firm’s assets. Define βE to be the beta of the firm’s equity. Use the CAPM along with M&M’s Proposition II to find the relationship between βA and βE.

c. G-20 is an all-equity firm which sells $100 pens and $100,000 tables to Harper Inc. G-20 earns an EBIT of $3.75 million this year which grows at 20% for the next 6 years, and then grows at 15% thereafter. The required rate of return on equity is 22%. Assuming no tax, what is the value of G-20? What is the WACC of G-20? If G-20 decides to use $50 million debt at 11% to retire equity, what will be the WACC? Now if the corporate tax rate is 40%, how much will be the addition to value due to the $50 million debt?

Summary

This question belongs to finance and discusses about Capital Structure of The Playhouse Disney and Treehouse Companies.

Word count: Excel Format