Question
Pelitto Inc. has 100 million shares outstanding, trading at $50/share. The company has no debt outstanding and no cash balance. Its stock has a beta
Pelitto Inc. has 100 million shares outstanding, trading at $50/share. The company has no debt outstanding and no cash balance. Its stock has a beta of 0.90, the risk free rate is 3% and the equity risk premium is 6%.
a. The company is in stable growth and is expected to generate free cash flows, prior to debt payments but after taxes and reinvestment needs, of $ 250 million next year. Given the market value of the company, what is the implied growth rate? (1 point)
b. Now assume that Pelitto plans to borrow $2 billion at a pre-tax cost of debt of 7% and return the cash to equity investors. If the marginal tax rate is 40%, what effect will the borrowing have on firm value, assuming that your savings grow at the implied growth rate from part a? (2 points)
c. Assume that cash return (in part b) took the form of a special dividend (the $2 billion is borrowed and paid out as a dividend). What will the stock price be after the special dividend? (1 point)
d. Assume that Pelitto uses the $2 billion to buy back shares (instead of paying a special dividend). What would the buyback price have to be for the remaining shares to see trade at $51/share after the buyback? (2 points)
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