Question

I HAVE ALL ANSWERS EXCEPT FOR D.

Locomotive Corporation is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firm’s debt–equity ratio is expected to rise from 35 percent to 50 percent. The firm currently has $3.4 million worth of debt outstanding. The cost of this debt is 8 percent per year. The firm expects to have an EBIT of $1.33 million per year in perpetuity and pays no taxes.

  

a.	What is the market value of the firm before and after the repurchase announcement? (Enter your answers in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.)

  

	Market value
Before	$   13114286
After	$   13114286

  

b.	What is the expected return on the firm’s equity before the announcement of the stock repurchase plan? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

  

Expected return

% 10.89

  

c.	What is the expected return on the equity of an otherwise identical all-equity firm? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

  

Expected return

% 10.14

  

d.	What is the expected return on the firm’s equity after the announcement of the stock repurchase plan? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

  

Expected return

% ???

Answer 1

ANSWER:

Required d)

Expected return on the firm’s equity after the announcement of the stock repurchase plan

Given:

Old debt-equity ratio = 35%

New debt-equity ratio = 50%

Worth of debt outstanding = $3,400,000

Cost of debt = 8% per year

EBIT = $1,330,000 per year

As given in the (c) part  expected return on the equity of an otherwise identical all-equity firm is 10.14%

i.e. R1 = 10.14%

Cost of equity = R1 + [New debt-equity ratio * (R1 - Cost of debt)]

Cost of equity = 10.14% + [50% * (10.14% - 8%)]

Cost of equity = 0.1014‬ + (0.50 * 0.0214‬)

Cost of equity = 0.1014 + 0.0107‬

Cost of equity = 0.1121 or 11.21‬%