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 $3 million worth of debt outstanding. The cost of this debt is 8 percent per year. The firm expects to have an EBIT of $1.29 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? (

Answer 1

Ans:-(a) In this case we need to find the value of the firm before and after the repurchase announcement.

In this case, taxes are absent, therefore the value of leverage firm will be equal to the value of the unleveraged firm.

As per this question, the debt-equity ratio is given 30% and debt and the value of debt is $3 million i.e 3000000.

Now the value of equity will be 3000000/30% = 10000000.

Value of the firm is given by (Value of debt + Value of equity)

= 3000000 + 10000000 = $13000000.

Therefore the value of the firm before and after the repurchase announcement will be $13000000 as there are no taxes.

(b) Expected return on the firm's equity before the announcement of the stock repurchase plan will be given by

(EBIT - Interest) / Equity Value

Interest will be given by (Value of debt value * cost of debt percentage)

Interest = 3000000 * 8% = 240000.

Expected return on equity = (1290000 - 240000) / 10000000 = 10.50%.

(c) In this case, we need to find the expected return on equity for an unlevered firm since there are no taxes, therefore the value of a levered firm will be equal to the value of the unlevered firm.

Therefore the return on equity will be EBIT/value of an unlevered firm i.e value of the firm.

=1290000/13000000

=9.92%.

(d) Expected return on the firm's equity after the announcement of the stock repurchase plan will be given

Return on all equity + debt ratio * ( Return on equity - cost of debt percentage)

= 9.92 + 0.50 * ( 9.92 - 8)

= 10.88%

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