A firm currently has equity with a market value of $600,000,000 and debt with a
ID: 2716428 • Letter: A
Question
A firm currently has equity with a market value of $600,000,000 and debt with a market value of $500,000,000. The firm has 10,000,000 shares outstanding. The bonds offer investors a return of 8%. The firm is contemplating issuing $300,000,000 in new equity and using the proceeds to repurchase $300,000,000 of the firm's debt. The corporate tax rate is 35%, the effective personal tax rate on equity income is 10% and the effective personal tax rate on interest income is 20%.
a). What will the firms stock price be immediately after the firm announces its refinancing plan?
b). How many shares will the firm issue?
c). What is the market value of the firm's (i) debt and (ii) equity immediately before the refinancing plan is announced?
d). Calculate the market value of the firm's (i) debt and (ii) equity immediately after the refinancing plan is announced (but before it is actually excuted) e). Calculate the market value of the firm's (i) debt and (ii) equity after the equity issue and bond repurchase are completed.
Explanation / Answer
that VL= VU+ [TGx D]
where TG=[1 –(1-TC)(1-TE)/(1-TD) ],
and D = debt.Thusif we have two debt levels, say D1and D2,
VL1= VU+ [TGxD1]and VL2= VU+ [TGxD2]
and thus the change in firm value going from D1to D2is given by VL2- VL1= TGx[D2- D1]
.In this problem D2- D1= -$200,000,000so the market value of the firmshould decrease by TGx200000000 where TG=[1 –(1-TC)(1-TE)/(1-TD) ]= [ 1-(.65)(.90)/(.80)] = 0.26875.
Thus firm value will decrease by $200000000 x 0.26875 =53750000.
The stock price before the announcement was$500 and after the announcement it should drop by 53750000/10,000,000 = $5.375 re.Thus theprice after announcement will be 60 –5.375=$54.625
answer 2
new shares => 300,000,000 / 54.625 => 5491991 shares
answer C
market value before financing plan
Market value of Equity => $600,000,000
Market value of Debt => $600,000,000
Answer d
The market value of the firm's (i) debt and (ii) equity immediately after the refinancing plan is announced (but before it is actually excuted)
Equity => 600,000,000 - 53,750,000 => $ 546,250,000
Debt => $ 500,000,000
Answer e
The market value of the firm's (i) debt and (ii) equity after the equity issue and bond repurchase are completed.
Equity => $ 546250000 + 300000000 => $846,250,000
Debt => 500000000 - 300000000 => $ 200,000,000
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