Lecture18b_winter09

Lecture18b_winter09 - CAPITAL STRUCTURE AND VALUE OF THE...

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CAPITAL STRUCTURE AND VALUE OF THE FIRM
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EXAMPLE Green Manufacturing plans to announce that it will issue $2m in perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a 6% annual coupon rate. Green is currently an all-equity firm, worth $10m with 0.5m shares. After the sale of the bonds, Green will maintain the new capital structure indefinitely. Green currently generates annual pretax earnings of $1.5m. This is supposed to continue in perpetuity and the tax rate is 40%
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EXAMPLE You may think the new structure will be Debt $2m and Equity $8m, but that will not happen. You may think that the proceeds from the bond issue will buy 100,000 shares, but that will not happen.
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EXAMPLE a) What is the expected return on Green’s equity before the announcement? b) What is Green’s market value balance sheet before the announcement? What is the price per share? c) Construct Green’s market value balance sheet after the announcement?
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