Firm R currently has $1,000,000 of debt outstanding with a before tax annual cou

Question

Firm R currently has $1,000,000 of debt outstanding with a before tax annual coupon of 5%, a constant EBIT of $2,000,000 and 400,000 shares outstanding at a market price of $25.00. The firm is considering issuing $1,500,000 of debt at a before tax cost of 6.5% 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 32%. What is the market value of the firm before the announcement of the issue of the new debt?

Explanation / Answer

Calculate the market value of the firm before the announcement of the issue of the new debt:

Using market capitalization method:

Company current market price is $25.00

Number of shares available = 400,000

Repurchase of stock ($1,500,000 /$25) = 60,000 shares

Remaining shares available (400,000 -60,000) = 340,000 shares

Market value of the firm (340,000 shares *$25) = $8,500,000

Therefore, market value of the firm is $8,500,000.

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