Question
At the end of the year the economy will be in one of the following three equally likely states: bad, neutral or good. The risk-free
At the end of the year the economy will be in one of the following three equally likely states: bad, neutral or good. The risk-free rate is 5% and the expected return on the market portfolio is 12%. There are no corporate taxes or costs of financial distress. Vertex Energy is an all-equity firm and has an equity beta of 0.8. The value of its assets in one year, depending on the state of the economy, is as follows:
State Bad Neutral Good
Assets 70 150 260
The firm plans to issue a one-year bond with a face value of $100 and a coupon rate of 30% and to use the proceeds from the bond issue to pay out a special dividend. The firms debt will have a beta of 0.40.
a. What is the market capitalization before the change in capital structure?
b. What is the market capitalization after the change in capital structure?
c. What is the equity beta after the change in capital structure?
d. What is the expected return on equity after the change in capital structure?
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