Paul Rosenzweig is founder and CEO of OpenStart, an innovative software company. The company is all equity financed, with 100 million shares outstanding. The shares are trading at a price of $1. Campbell currently owns 20 million shares. There are two possible states in one year. Either the new version of their software is a hit, and the company will be worth $180 million, or it will be a disappointment, in which case the value of the company will drop to $75 million. The current risk free rate is 3%. Rosenzweig is considering taking the company private by repurchasing the rest of the outstanding equity by issuing debt due in one year. Assume the debt is zero-coupon and will pay its face value in one year.

a. What is the market value of the new debt that must be issued?

b. Suppose OpenStart issues risk-free debt with a face value of $75 million. How much of its outstanding equity could it repurchase with the proceeds from the debt? What fraction of the remaining equity would Jim still not own?

c. Combine the fraction of the equity Jim does not own with the risk-free debt. What are the payoffs of this combined portfolio? What is the value of this portfolio?

d. What face value of risky debt would have the same payoffs as the portfolio in (c)?

e. What is the yield on the risky debt in

(d) that will be required to take the company private?

f. If the two outcomes are equally likely, what is OpenStart’s current WACC (before the transaction)?

g. What is OpenStart’s debt and equity cost of capital after the transaction? Show that the WACC is unchanged by the new leverage.

Capital Structure Fallacies AppendixLO1