Question

The TQM Corporation is located in a country where there are perfect capital markets and no taxes.... 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?

Answer 1

1. The total value of the firm will be same as the value of its equity which is going to be $ 180 million

2. The cost of equity will be at 18% (same as before the event) however the WACC will increase since there will be no debt.

3. Prior to refinancing, TQM has $120 million in equity and $60 million in debt. Hence Sheila through her $1 million TQM stock had equity holding of 2/3 and debt holding of 1/3 through TQM. Hence her pesonal holding across equity & debt was : Equity = 2/3 * 1000000 = 666,666.67

Debt = 2000000 + 1/3 * 1000000 = 2,333,333.33

After refinancing, her TQ holding will be all equity hence her holding pattern will be :

Equity = 1 million and Debt = 2 million.

If she wants to keep her portfolio break down at earlier levels, then she should sell the TQM stock for $333,333.33 and purchase risk free debt for the same .

4. The firm value should increase by the NPV value - hence the value will be $182 million