Question

AHP2 Inc. expects its EBIT to be $12,500 perpetually. The firm can borrow at 5% but currently has no debt, and its cost of equity is 12%. It has 10,000 shares outstanding. The tax rate is 21%. AHP2 plans to borrow $40,000 and use the proceeds to repurchase shares. The additional borrowing is not going to affect the firm’s credit rating and accordingly the expected bankruptcy costs.

AHP2 price per share will _______at the announcement of debt issuance and _________ at the time of actual recapitalization since markets incorporate new information immediately.

The cost of equity (Re) of the levered firm is _____ the cost of equity of the unlevered firm because ____.

The cost of capital (the weighted average cost of capital - WACC) of the levered firm is __________ the cost of capital (WACC) of the unlevered firm because _______.

Answer 1

AHP2 price per share will Higher at the announcement of debt issuance and Lower at the time of actual recapitalization since markets incorporate new information immediately.

The cost of equity (Re) of the levered firm is higher the cost of equity of the unlevered firm because debt increases risk to stockholders.

The cost of capital (the weighted average cost of capital - WACC) of the levered firm is Lower the cost of capital (WACC) of the unlevered firm because cost of debt is lower then cost of equity..