Question

Refi 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 30 percent to 50 percent. The firm currently has $2.7 million worth of debt outstanding. The cost of this debt is 9 percent per year. The firm expects to have an EBIT of $1.26 million per year in perpetuity and pays no taxes.

  

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

Answer 1

a. Debt Value =2,700,000
Debt to equity ratio =30%
2.7 Million/Equity =30%
Equity =2.7/30% =9 million
Market value of the firm = Debt + Equity =2700000+9000000 =11,700,000
Market Value of the firm after repurchase will not change as there are no taxes =11700000

b. Equity before repurchase =9 million
Return on Equity =(EBIT-Interest)/Equity =(1260000-2700000*9%)/9000000=11.30%

c. Equity value in all equity firm =Value of the firm =11700000
Return on Equity =(EBIT)/Equity =(1260000)/11700000 =10.77%

d. Cost of levered Equity = Cost of Unlevered equity + Debt Equity Ratio*(Cost of Unlevered Equity -Debt)
=10.77%+50%*(10.77%-9%) =11.65%