Use the following information to respond to the next four multiple choice questi

Question

Use the following information to respond to the next four multiple choice questions. Firm R currently has $500,000 of debt outstanding with a before tax annual coupon of 5.8%, a constant EBIT of $2,000,000 and 450,000 shares outstanding at a market price of $25.00. The firm is considering issuing $2,500,000 of debt at a before tax cost of 7% and using the proceeds to repurchase stock at the new post-announcement market price. If this plan is implemented, it is expected that the required return on equity would rise to 10%. The firm's marginal tax rate is 34%.

1.What is the market value of the firm before the announcement of the issue of the new debt?

$12,572,500

$13,277,500

$12,102,500

$11,750,000

2.What is the estimated value of the firm after the new debt issue?

$15,893,352

$16,784,568

$15,299,208

$14,853,600

3.What is the estimated share price after the capital structure change?

$34.13

$36.04

$32.85

$31.90

4.How many shares remain outstanding after the capital structure change?

397,636 shares

419,933 shares

371,622 shares

382,771 shares

Explanation / Answer

1. Market Value Before New Debt Issue = Value of Debt + Value of Equity

Market Value Before New Debt Issue = $500000 + 450000 * $25

Market Value Before New Debt Issue = $11750000

2. Estimated Value After Debt Issue

Estimated Value = ((EBIT - Interest) * (1 - Tax) / Return on Equity) + Value of Debt

Estimated Value = (($2000000 - $204000) * (1 - 0.34) / 10%) + $3000000

Estimated Value = (($1796000) * (0.66) / 10%) + $3000000

Estimated Value = (($1185360) / 10%) + $3000000

Estimated Value = $11853600 + $3000000 = $14853600

3. Estimated Price After Capital Structure Change

Estimated Price = Value of Equity / No. of Shares O/s After Share buy back

Estimated Price = $11853600 / 371622

Estimated Price = $31.90

4. Shares Remaining O/s

No. of Shares O/s = Shares O/s - Shares Purchased

No. of Shares O/s = 450000 - $2500000 / $31.90

No. of Shares O/s = 450000 - 78378

No. of Shares O/s = 371622

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