Capital Structure, MM Theory

You own 100 shares of ABC corp. that is into pipe manufacturing business. ABC corp. currently has 10000 shares outstanding. The firm has a total asset size of | 1 million entirely funded by equity. The firms EBIT is expected to be | 100,000 forever and the firm pays out all earnings as dividends. The cost of borrowing in the market is 8%. Assume perfect market conditions of MM world (no tax, same borrowing cost etc.)

1. Currently, what is ABC corp. stock price? [1 mark]

2. Suppose, ABC corp. comes up with a new idea to buy back shares from the market to replace equity. The idea is to add | 350,000 worth of debt. How many shares will be bought back? [1 mark]

3. What is the new stock price after the repurchase? [1 mark]

4. Suppose, the firm has moved from zero debt to having debt as mentioned in question 2. You still own 100 shares after the restructure. Though the firm has debt now, your preference is still the old unlevered earnings. Show using home made leverage how you can continue to earn the same earnings that you had before the restructure, even though you currently own shares of the levered firm. [2 marks]

5. Draw the market value balance sheet of the firm before and after the restructure. [2 marks]

6. Suppose, the taxes are now 25%. As per question 2, the firm has just announced the restructure. Redraw the market value balance sheet on the day of announcing the new debt. [1 mark]

7. In question 6, what is the new stock price? [1 mark]

8. Suppose, the firm has raised the debt and repurchased shares. How many shares would it repurchase now? [1 mark]

9. In question 8, after the repurchase, redraw the market value balance sheet. [1 mark]

10. What is the new share price once the repurchase is complete? [1 mark]