John is the new chairman of On Road Limited, a car producer in USA. The company specializes in production of lightweight, galvanized steel particularly for aircrafts. After meeting with the management team this morning, he discovered that Hot Rod is a pure equity firm with no debts. He realizes that the company is under-levered and not making full use of the tax benefit on debts. John is now considering issuing additional debts and uses the proceeds to repurchase outstanding shares.

At present, On Road has 2 million outstanding shares with a market price of $12 per share and zero debt. The tax rate for the firm is 30%. According to Johns proposed plan, the company will borrow $6 million by issuing 8% p.a. perpetual bonds to repurchase the outstanding shares. Before making an informed decision, there are several questions which need to be addressed.

Required:

a Explain the tax implication that On Road Limited will benefit from by changing from an unlevered firm into a levered firm. (3 marks)

b Evaluate the total value of On Road Limited Limited after becoming a levered firm. (8 marks)

c Assume John decides to set the repurchase price at $15 per share and distribute the entire tax shield benefit as a special dividend to remaining shareholders. Calculate the amount of dividend per share. (5 marks)

d Besides the benefit from tax shield, identify the factors that John should consider when making use of debt financing. (14 marks)

e If On Road Limited is not a listed company, advise the steps to calculate its WACC. (10 marks)