An unlevered company operates in perfect markets and has net operating income of

Question

An unlevered company operates in perfect markets and has net operating income of $250,000. Assume that the required return on assets for firms in this industry is 12.5%. Suppose the firm issues $1 million worth of debt with a required return of 5% and uses the proceeds to repurchase outstanding stock. (a) Calculate the market value and required return of this firm's stock before the repurchase transaction. (b) Calculate the market value and required return of this firm's remaining stock after the repurchase transaction

Explanation / Answer

Ans a) Market Value of firm = EBIT/require rate of retrun

= $250000/.125 = $2000000

required rate of retrun of firm's stock before the repurchase transaction = 12.5%

Ans b) After the repurchase, the firm has $1,000,000 debt and $1,000,000 equity, so the debt-to-equity ratio is 1 and the new required return on equity is rl = r + (r – rd)D/E = 0.125 + (0.125 - 0.05) x 1 = 0.125 + 0.075 = 0.2 or 20%.

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