Question

Green Manufacturing, Inc. plans to announce that it will issue $3 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will have a 6-percent annual coupon rate. Green is currently an all-equity firm worth $15 million, with 500,000 shares of common stock outstanding. After the sales of the bonds, Green will maintain the new capital structure indefinitely. Green currently generates annual pretax earnings of $3 million. This level of earnings is expected to remain constant in perpetuity. Green is subject to a tax rate of 40 percent.

a) What is the required return on Green’s equity before the announcement of the debt issue?

b) Construct Green’s market-value balance sheet before the announcement of the debt issue. In other words, what is the market value of the firm? What is the market value of debt? What is the market value of equity? Finally, What is the price per share of the firm’s equity?

c) Construct Green’s market-value balance sheet immediately after the announcement of the debt issue but before the issue itself. Calculate the market value of the firm, the market value of debt, and the market value of equity.

d) What is Green’s stock price per share immediately after the repurchase announcement?

e) How many shares will Green repurchase as a result of the debt issue? How many shares of common stock will remain after the repurchase?

f) Construct Green’s market-value balance sheet immediately after the restructuring. In other words, calculate the market value of the firm, the market value of debt, and the market value of equity.

g) What is the required return on Green’s equity after the restructuring?

Answer 1

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