Question

Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 40 percent debt. Currently, there are 2,000 shares outstanding and the price per share is $7. Its assets will be worth $21,500 in one year if the economy is strong, and $10,000 in one year if the economy is weak. Both events are equally likely. The interest rate on new debt is 8 percent, and there are no taxes.

a. What is the expected return of Star stock without leverage?

b. If Star converts to the capital structure that consists 40 percent debt today and uses the proceeds from issuing debt to repurchase shares of existing stock, what will be the market value of its equity after the repurchase? How many shares of stock can Start repurchase?

c. What is the expected return of Star stock after the transaction in part (b)?

Answer 1

Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 40 percent debt. Currently, there are 2,000 shares