In: Finance
Section 2: Capital Structure
An unlevered company operates in perfect markets and has
earnings before interest and taxes (EBIT) of $3m. Assume that the
required return on assets for firms in this industry is 10%. The
firm issues $15m worth of debt with a required return of 6% and
uses the proceeds to repurchase outstanding stock. There are no
corporate or personal taxes.
a) What is the market value of the firm and required return of this
firm’s stock before the repurchase transaction, according to M
& M Proposition I?
b) What is the market value of the firm and the required return and
the required return on the firms remaining stock after the
repurchase transaction, according to M & M Proposition
II?