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Capital Structure and Leverage - Solutions4

# Capital Structure and Leverage - Solutions4 - The company...

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 16 of 59 Pages The company is considering issuing \$2 million worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated yield to maturity of 5 percent. The risk-free rate in the economy is 4 percent, and the market risk premium is 6 percent. The company’s beta is currently 1.0, but its investment bankers estimate that the company’s beta would rise to 1.2 if it proceeds with the recapitalization. Assume that when the announcement is made that the firm will recapitalize, the market fails to increase the price of the stock in anticipation of the recapitalization and that the shares are eventually repurchased at the current price. Determine what the new (eventual) equilibrium price of the firm’s stock will be after the debt is finally issued and shares have been repurchased. A. \$19.63 B. \$20.29 C. \$20.61 * D. \$20.44 E. \$19.86 K D = 5% Interest expense = (\$2,000,000) (0.05) = \$100,000 Current K S = .04 + (.06)(1.0) = 10% New K S = .04 + (.06)(1.2) = 11.2% Current value of firm/stock = (\$1,500,000)(1 - .35) / 0.10 = \$9,750,000 Current price of stock = \$9,750,000 / 500,000 = \$19.50 per share Alternatively: EPS = DPS = (\$1,500,000)(1 - .35) / 500,000 = \$1.95 per share Current price of stock = \$1.95 / .10 = \$19.50 per share Number of shares to be bought back (current price) = \$2,000,000 / \$19.50 = 102,564 Number of shares left outstanding = 500,000 - 102,564 = 397,436 New value of stock = [\$1,500,000 - \$100,000][1 - .35] / .112 = \$8,125,000 New price per share after debt issue and buy back = \$8,125,000 / 397,436 = \$20.44 New EPS = DPS = [\$1,500,000 - \$100,000][1 - .35] / 397,436 = \$2.2897 New price per share after debt issue = \$2.2897 / .112 = \$20.44 17. Your company has made the following forecast for the upcoming year based on the

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 17 of 59 Pages
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Capital Structure and Leverage - Solutions4 - The company...

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