16.13 Because of the large cash inflows from the sales of its cookbook, Fear of Frying, the Overnight Publishing Company (OPC) has decided to retire all of its outstanding debt.

The debt is made up of consul bonds; its maturity date is indefinitely far away. The debt is also considered risk-free. It carries a 10-percent coupon rate and has a book value of $3 million. Because market rates on long-term bonds are 15 percent, the market value of the bonds is only $2 million. All of the debt is held by one institution that will sell it back to OPC for $2 million cash. The institution will not charge OPC any transaction costs, and there are no tax consequences from retiring the debt. Once OPC becomes an all-equity firm, it will remain unlevered forever.

If OPC does not return the debt, the company will use the $2 million in cash to buy back some of its stock on the open market. Repurchasing stock also has no transaction costs. Investors expect OPC to repurchase some stock, so they will be completely surprised when the debt-retirement plan is announced.

The required rate of return of the equity holders after OPC becomes all equity will be 20 percent. The expected annual earnings before interest and taxes for the firm are

$1,100,000; those earnings are expected to remain constant in perpetuity. OPC has no growth opportunities, and the company is subject to a 35-percent corporate tax rate.

Assume that TB
= 10% and TS =
0. Also assume that bankruptcy costs do not change for OPC as a result of this capital-structure change. How much does the market value of the company change?