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Question #3. Windsor, Inc. is currently an all-equity financed firm, and its cost of equity is...

Question #3.

Windsor, Inc. is currently an all-equity financed firm, and its cost of equity is 12%. It has 20,000 shares outstanding that sell for $25 each. The firm contemplates a restructuring that would borrow $100,000 in perpetual debt at an interest rate of 8% which will be used to repurchase stock. Assume that the corporate tax rate is 35%.

(1) Calculate the present value of the interest tax shields and the value of the firm after the proposed restructuring.

(2) What will be shareholders’ required rate of return after the proposed restructuring? Is it higher or lower than 12%? Why or why not?

Question #4.

State the dividend irrelevance proposition. What are the assumptions behind this proposition? Explain why this proposition does not hold in the real world.

Solutions

Expert Solution

Question no-3 answer

1) calculation of present value of the interest tax shield:-

This is perpetual debt

Therefore, Formula is

PV of interest on tax shield =( loan amount * interest rate * tax rate) / interest rate.

= ($100,000 * 8% * 35%) / 0.08

=$ 35,000

PV of interest on tax shield = $ 35,000

Calculation of value of firm:-

Before restructuring:-

Here the firm is unleavered firm, there is no debt.So, the market value of firm is equal to market value of equity.

Value of firm = market value equity.

Value of firm = 20,000 shares *$ 25 = $500,000

After restructuring:-

As capital structure change, debt issued = $ 100,000

As money this used to repurchase the stock.

Here the firm is leavered firm. The firm having debt.So, value of firm is equal to market value of debt & equity.

Value of firm = value of debt + value of equity.

Value of debt =$100,000

Remaining equity value = value of unleavered firm - debt value

Equity in leavered firm = $500,000 -$ 100,000 = $400,000

Value of firm = $100,000 + $ 400,000 =$ 500,000

There is no change cin value of firm before & after debt issue.

2)

The shareholders required rate of return is higher than the 12% after the proposed restructuring.

Because of rate of decrease in equity is more than the rate of decrease in earning available to shareholders.

jeff jeffy answered 1 year ago
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