Microsoft Word - Ps6.doc

1. Backyard Utility is an all-equity firm, and is expected to generate an EBIT of $2 million per year. In order to grow fast at a rate of 7%, Backyard needs to retain 80% of earnings for investment. The remaining will be paid out as dividends. The firms corporate tax rate is 25%.
   1. (a) If the firm is valued at $10 million, what is the expected return of the firm? (Hint: use dividend growth model)
   2. (b) Now assume the firm issues $4 million of debt paying interest of 3% per year, using the proceeds to repurchase equity. The debt is expected to be permanent. What is the equity value of the firm after refinancing?
   3. (c) What is the required return on equity after refinancing? Why does your answer make sense?
   4. (d) In order to maintain the same payout ratio of 20% after refinancing, what growth rate will Backyard enjoy on its earnings? (Hint: the equity value is what you computed in (b), which can also be calculated in the similar way as in (a))