Alberta Utilities (AU) is a Calgary-based energy company that has been highly profitable over the past few years. Since there are no financially feasible alternatives to conventional fuel in sight, prices for energy-related commodities have been, and are expected to stay, high for years. Given this optimistic outlook, AU management is considering a leveraged buyout (LBO) to take the publicly traded AU private. You, an assistant to the CFO, have been assigned to study this possibility. AUs basic information is as follows:

There are 25 million ordinary shares outstanding, currently traded on the stock exchange at $15 per share. Its debt has market value of $100 million at an interest rate of 10%. AUs corporate tax rate is 40%.

Required

• The finance department has prepared a long-term financial projection showing AUs earnings before interest and taxes (EBIT) to be $80 million per year in perpetuity. AU pays out all the earnings available to shareholders as dividends. Calculate AUs cost of equity implicit in its current market value of equity and its projected EBIT.

• Calculate AUs current debt-to-asset ratio and WACC.
• Calculate and show that the unlevered cost of equity is lower than the current levered cost of equity.
• Calculate and show that the value of an all-equity firm (also the value of unlevered equity) and the value of equity of a levered firm are different.

• AU management is planning to take out a new loan at the same 10% interest rate to repurchase ordinary shares in order to increase AUs debt-to-asset ratio to 90%.

• Calculate the amount of the new loan.
• Calculate the share price after the share repurchase according to Modigliani and Miller (M&M).
• Calculate the number of ordinary shares outstanding after the share repurchase.

• Indicate one motivation behind the LBO. Briefly discuss potential agency and ethical issues associated with:

• A firms leveraged share repurchase
• An insiders leveraged buyout