3a. Wonderland Entertainment is currently a fully equity funded company and it has 1 million shares outstanding with a m

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3a. Wonderland Entertainment is currently a fully equity funded
company and it has 1 million shares outstanding with a market price
of £10.00 per share. Given the risk of the company’s future cash
flows, the estimated cost of capital is 15%. Suppose the management
is now considering issuing debt with a market value of £5 million
to buy back its shares. The company can borrow at a rate of 8%.
REQUIRED:
i. Assuming a perfect market, what is the expected return on
equity after the transaction?
ii. Suppose the company pays corporate income tax at rate 40%.
What is the company’s
after-tax WACC after the transaction?
iii. Suppose the company pays corporate income tax at rate 40%.
If the price of Wonderland Entertainment’ stock rises to £10.50 per
share following the announcement of the recapitalization plan, what
is the present value of the company’s financial distress costs?
3b. Discuss the trade-off theory of capital structure and its
predictions of companies’ debt ratios.
3c. Rubyist Techologies’ assets are currently valued at a market
value of £45 million while it holds a £50 million loan due at the
end of the year. The management is currently considering a new
business strategy. If the new strategy succeeds, the total market
value of the company will increase to £60 million. Alternatively,
if the new strategy fails then the company will have a market value
of £20 million. Suppose that these two scenarios are equally
likely.
REQUIRED:
i. What are the expected payoffs to the debt and equity holders
if the management decides
to switch to the new strategy? What would be equity holders and
debt holders’
preferences regarding decision-making for the new strategy?
ii. Describe the economic concept that is illustrated in the
situation above?
3d. D3 Tech Ltd pays a quarterly dividend of £10 per share and
its share price typically drops by £7 per share when the stock goes
ex-dividend. Suppose that all capital gains are taxed at a rate of
15%. Two investors, Alex and Leo, are considering a trading
strategy to capture the dividends but they are in different tax
brackets for dividend income (35% for Alex and 45% for Leo).
REQUIRED:
i. Assuming no transaction costs, who should buy D3’s stock and
capture its dividends?
Why?
ii. Briefly discuss the implication of the Dividend-Capture
Theory.