Question

An all-equity firm with a market value of $3,500,000 is considering a restructuring, in which it will issue $800,000 of debt and use the proceeds to repurchase stock. The required return on equity before the restructuring is 15%, and the required return on the new debt will be 8%. The firm pays no taxes. What will the required return on equity be after the repurchase?

Answer 1

After restructuring:

Required Return on Equity before restructuring, r = 15%
Required Return on debt, rd = 8%

Value of Firm = $3,500,000
Value of Debt = $800,000

Value of Equity = Value of Firm - Value of Debt
Value of Equity = $3,500,000 - $800,000
Value of Equity = $2,700,000

D/E = Value of Debt / Value of Equity
D/E = $800,000 / $2,700,000
D/E = 0.2963

Required return on equity after restructuring, re = r + (r - rd)*D/E
Required return on equity after restructuring, re = 0.15 + (0.15 - 0.08)*0.2963
Required return on equity after restructuring, re = 0.1707
Required return on equity after restructuring, re = 17.07%