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An all-equity business has 100 million shares outstanding, selling for $20 a share. Management believes that...

An all-equity business has 100 million shares outstanding, selling for $20 a share. Management believes that interest rates are unreasonably low and decides to execute a dividend recapitalization. It will raise $1 billion in debt and repurchase 50 million shares.

Assuming the Irrelevance Proposition holds, what is the market value of the firm after the recap? What is the market value of equity?

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Answer #1

a) Market value of firm = No of sahres*price per share = 100 mill*20 = 2000 Mill. OR 2 billion.

) Under irrelevance theory OR MM model use of debt doesn't impact the value of the firm. Value of firm is dependent on its earnings capcaity and change in financing mix has no impact on value of firm. Though use of debt increase the value of firm equivalent to tax shield but since here no tax rate is given it is taken that there is no tax. Accordingly value of firm, in this case, will be $2 billion (as calculated in part a above)

Value of equity = value of firm - value of debt = 2 billion - 1 billion = $1 billion

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