Question

ZeroLeverage Co is a manufacturing firm. The company generates an EBIT of $250,000 per year and forever. ZeroLeverage Co will always distribute its earnings as dividends to its shareholders. ZeroLeverage Co’s current capital structure includes 100% equity. There are 100,000 shares of common stocks outstanding. ZeroLeverage Co’ project has a market beta 1.5. The risk-free asset is yielding 5% per year, and the market risk premium is 5% per year.

Recently, the CEO of ZeroLeverage Co, Mr. Peter Kyle, attended a Corporate Finance class. He learned that different capital structure may have some impacts on firm value. ZeroLeverage Co currently faces 35% corporate tax rate. Although ZeroLeverage Co doesn’t have any debt, many investment banks and financial advisors have approached Mr. Peter Kyle about the possibility of issuing bonds or borrowing from banks. Due to its good reputation, ZeroLeverage Co can get very favorable interest rates of 7%. Mr. Peter Kyle wants to know if it is a good idea to issue some debt and use the proceeds to buy back shares. To be specific, Mr. Peter Kyle is thinking about a potential start at issuing $1 million perpetual debt paying 7% interest per year and uses the money to buy back some shares of common stocks. Please help him evaluate the following questions.

(a) What is the expected rate of return for ZeroLeverage Co’s stock? (b) (3 points) What is the market value of ZeroLeverage Co if it keeps 100% equity? And what is ZeroLeverage Co’s stock price as an all-equity firm?

(c) What will be the market value of ZeroLeverage Co if it issues $1 million of perpetual debt paying 7% interest per year and uses the money to buy back some shares of common stocks?

(d) If ZeroLeverage Co issues $1 million of perpetual debt and uses the money to buy back some shares of common stocks, how many shares of common stocks will ZeroLeverage Co be able to buy back and what is the new stock price?

(e) What is the cost of equity and WACC of ZeroLeverage Co after it issue the debt?

(f). What are the possible relationships between capital structure and firm value under MM theorem without corporate tax and bankruptcy cost, under the MM theorem with only corporate tax, under the MM theorem with both corporate tax and bankruptcy cost?

Answer 1

(a) What is the expected rate of return for Zero Leverage Co’s stock?

Answer) 12.500%

(b) What is the market value of Zero Leverage Co if it keeps 100% equity?

And what is Zero Leverage Co’s stock price as an all-equity firm?

Market value	1300000
Stock Price	13

(c) What will be the market value of Zero Leverage Co if it issues $1 million of perpetual debt paying 7% interest per year and uses the money to buy back some shares of common stocks?

Answer) 2545181

(d) If Zero Leverage Co issues $1 million of perpetual debt and uses the money to buy back some shares of common stocks, how many shares of common stocks will Zero Leverage Co be able to buy back and what is the new stock price?

76923 share buyback

New share price 67

(e) What is the cost of equity and WACC of Zero Leverage Co after it issue the debt?

WACC: 6.38%

(f) What are the possible relationships between capital structure and firm value under MM theorem without corporate tax and bankruptcy cost, under the MM theorem with only corporate tax, under the MM theorem with both corporate tax and bankruptcy cost?