Beta plc is an all-equity firm with 500,000 shares of equity outstanding. The current price
per share is £20. Beta is planning to announce that it will issue £5 million of perpetual
bonds and use the proceeds to repurchase equity. The required return on the bonds is
6%. After the sale of the bonds, Beta will maintain the same capital structure indefinitely.
The company currently generates annual pre-tax earnings of £1 million. This level of
earnings is expected to remain constant in perpetuity. The company is subject to 20%
corporate tax rate. Assume that there are no transaction costs or financial distress costs.
REQUIRED
i) What is the expected return on Beta's equity before the announcement of the debt
issue? How many shares will the company repurchase as a result of the debt issue?What is the required return on Beta's equity after the restructuring?
Now assume that there is cost of financial distress that depends on the level of debt.
(B). Specifically, the expected cost of financial distress (CFD) for Beta plc is given by
CFD=(1/9,000,000)×B2. What is the level of debt and equity that maximises the
value of Beta?
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