The TQM Corporation is located in a country where there are perfect capital markets and no taxes. The corporation currently has $120 million in equity and $60 million in risk free debt. The return on equity, rS, is 18% and the cost of debt, rB, is 9%. Suppose TQM decides to issue additional equity to repurchase the $60 million in debt so that it will have an all-equity capital structure.
1. If TQM did this, what would the total value of the firm be after the refinancing?
2. What would the return on equity, rS, be after the refinancing?
3. Before the refinancing, a shareholder, Sheila, holds $1 million of TQM stock and $2 million of risk free debt. What is her holding of TQM stock and risk free debt after the refinancing, if she wants to keep the same level of risk in her portfolio?
4. After the refinancing, suppose the firm announces a project costing $5 million with an NPV of $2 million. Investors do not anticipate the project. The project is to be financed entirely by debt. What is the total value of the firm's equity after the debt for the project has been raised?
.1. Given the perfect markets and no taxes, the firm value will remain unchanged at $180 million
2. The return on equity will also remain unchanged at 18% though the company WACC will increase since there is no debt after refinancing
3. Sheila holds 2 million of debt directly and through TQM she was holding equity (120/180) 2/3 of 1 million and debt (60/180) 1/3 of a million. After the refinancing, the TQM will all equity hence her direct and indirect portfolio allocation will be:
Debt = 2 million
Equity = 1 million
If she wants the pre refinance portfolio allocation, she can simply sell 1/3 TQM stock and purchase risk free debt for the same amount.
4. Since the markets are perfect and there are no taxes (hence no tax shield on debt), the increase in the firm value will be equal to NPV. Hence the firm value will be $182 million and the equity value will be $177 million
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