3. Your firm is considering altering its capital structure and you have been tasked with analyzing the implications of the potential change. It currently has no debt and has 10 million shares outstanding but is considering issuing $50 million in debt and using the proceeds to repurchase shares at their current market value. The current forecast of the firms performance for next year (its final year) is that there are three possible outcomes, each with equal probability: liquidating cash flow of $80 million, $110 million, and $140 million, respectively. The appropriate cost of capital when the firm is all equity is 10%. Assume there are no taxes.

a. What is the appropriate per share value of its shares before the capital structure change? What are the three possible payments to the equity holders next year under the current capital structure?

b. Assume that the capital structure change is done and that the debt holders require a 5% rate of return on the debt. What are the three possible payments to the equity holders next year?

c. Because the equity is riskier, the appropriate cost of capital for the equity holders after this capital structure change will now be 15%. What is your estimate of the new share price at which the shares should trade? (

d. Imagine for a moment that managers were compensated with a bonus that increases with the stock price as long as it is above the stock price found in (a). Based on your answer to

(c), has this capital structure change created value? How will managerial bonus compensation differ under these two capital structures? (20)