CP expects its 1989 EBIT of $30,000,000 to remain relatively constant into the future.

CP has 10,000,000 shares of common stock outstanding, and they are traded in the over-the-counter market. The current share price is $12, so the total value of the equity is $120 million. The book value of the assets is also $120 million, so the stock now sells at its book value. CP's current tax rate is 40 percent. the trio agreed on these estimates for the relationship between the use of debt financing and CP's capital costs:

Amount BorrowedCost of DebtCost of Equity

$0--15.0%

25,000,00010.0%15.5

50,000,00011.016.5

60,000,00012.017.2

75,000,00013.018.0

100,000,00016.020.0

125,000,00020.025.0

If CP were to recapitalize, the borrowed funds would be used to repurchase stock in the open market.

Some equations:

(1) S = [EBIT - k_d(D)](1- T)/k_s.

(2) V = S + D.

(3) P = (V - D₀)/n₀.

(4) n₁ = n₀ - D/P.

in which

S = market value of equity.

EBIT = earnings before interest and taxes.

k_d = cost of debt.

D = market (and book) value of new debt.

D₀ = market value of old debt.

T = corporate tax rate.

k_s = cost of equity.

V = total market value.

P = stock price after recapitalization.

n₀ = number of shares before recapitalization.

n₁ = number of shares after recapitalization

1. Now assume that CP does recapitalize.

a. Estimate CP's stock price with and without debt.

b. How many shares would remain after recapitalization under each scenario?

c. Considering only the six levels of debt proposed in the case, what is CP' optimal capital structure?