Consider an infinite-date risk neutral economy in which the interest rate is 10%. An established firm generates cash flows of $1 million per period. There is a 20% corporate income tax levied upon corporate benefits. For fiscal purposes corporate benefits are defined as the difference between cash- flows and net financial expenses (interests paid - interests earned) in each period. There are no personal taxes.

For historic reasons the firm is financed 100% with equity, with 1 million shares outstanding, and it pays out as dividends 100% of the benefits in each period. The firm is considering issuing perpetual debt with a face value of $4 million and a 10% coupon. The firm does not have any new investment opportunities, thus, if the proceeds from the issuing of debt result in a net increase in financing, the extra funds will be invested in buying marketable securities that, at the current interest rates, are expected to yield 10% per period.

Keeping into account that the objective of the plan is to benefit the share- holders by saving taxes due to the tax shield of debt, the firm is considering the possibility of paying out an extraordinary dividend with the extra funds instead of investing them in marketable securities.

1. Calculate the value of the shares if the firm continues to finance 100% with equity. Explain why the dividend policy of the firm can be considered optimal.
2. Calculate the expected proceeds from the issue of debt. Which is the amount of the interest to be paid per period?
3. If no extraordinary dividend is paid after the issue of debt, which will be the amount of the interests earned per period? Which will be the value of the shares after the issue of debt?
4. If the extraordinary dividend is paid, how much will the shares be worth? How much will the shareholders obtain with this leveraged recapitalization transaction?