XYZ Ltd is currently all equity financed with a market value of $1 million. Its

Question

XYZ Ltd is currently all equity financed with a market value of $1 million. Its management is considering the issue of bonds with a face value of $500,000 (issued at face value). The new funds raised will be used to repurchase shares from existing shareholders.

a) Illustrate the effect of leverage in a world with no taxes by sketching the relationship betweenthe cost of equity and leverage for the all equity situation and the proposed (50% debt, 50% equity) on a fully labeled graph.

b)All firms face business risk. What additional risk do shareholders face under the proposed structure? Illustrate the second of these two risks by rearranging the weighted average cost of capital equation

c)If XYZ Ltd operated in a world governed by the restrictive assumptions of Modigliani and Miller (including the ability to issue risk free debt), what impact, if any, would the issue of new debt have of the company

Explanation / Answer

a) As leverage increases, firm is assumed to be more risky . Hence beta of the firm increases, which ultimately makes cost of equity to increase.

b) Shareholder will have subordinate claim on wealth incase of firm liquidation.

If increase risk leads to increase wacc then it will lead to decrease in firm value and shareholders wealth.

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