Question

An all-equity firm is subject to a 30% corporate tax rate. Its total market value is initially $3,500,000. There are 175000 shares outstanding. It announces that it will issue $1 million of bonds at 10% interest and uses the proceeds to buy back common stock (Assume no change in costs of financial distress)

a. what will happen to the market value of equity at the announcement of the share repurchase?

b. How many shares can the firm buy back with the $1 million bond issue?

c. The cost of unlecered equity (r0) is 20%. Use MM's II proposition to calculate the rate of return demanded by shareholders after the share repurchase?

d. create the market value balance sheet after the share repurchase.

Answer 1

A). When a company buys back shares, it's generally a positive sign because it means that the company believes its stock is undervalued and is confident about its future earnings. Share repurchases can have a significant positive impact on an investor and place upward pressure on stock price.

B).price per share = market value / outstanding shares

= $3.5millon/175,000=$20 per share

With $1millon bond issued we can buy back= $1millon/$20 per share = 50,000 shares only.

C). Rate of return on MM2 preposition is:-

R_E = rate of return on equity

Ro = Cost of unlevered equity = 20%(given)

R_D = Cost of debt. = 10%

D and E = they are market value of firms debt and equity respectively.

Where E =175,000-50,000( buyback)= 125,000*20per share price=2.5millon

tc = corporate taxes =30%

Therefore Re =20% +($1millon/$2.5millon)*(1-30%)*

(20%-10%) =22.8%

D).

Market value of company is

Equity= 125,000*20=$2.5millon

10%bonds= $1millon

Total = 3.5 million