PharmaTech is an unlevered firm operates in perfect markets and has net operating income (EBIT) of 1.50 million per year for the foreseeable future. Assume that the required rate of return on assets for firms in this industry is 8 per cent. The firm issues 6 million worth of debt, with a required rate of return of 5 per cent, and uses the proceeds to repurchase outstanding shares. There are no corporate or personal taxes. Joseph shares the following information with you so that you can evaluate the effect of financial leverage.

Table 1: Current and Proposed Capital Structure of PharmaTech

To help Joseph in recapitalisation, you had to go through various documents of PharmaTech. You have noticed that in the last three years, Joseph did not undertake many positive net present value (NPV) long term projects. You have also found that PharmaTech had the necessary funds to undertake these projects. Your initial assessment indicates that had these projects been undertaken, PharmaTech could have become the leader in such technologies: the firm could grow at a faster pace compared to the pace it is growing now, and thus shareholders would have been wealthier.

By exploring various other recent documents, you have found that Joseph is considering to take a project to develop COVID-19 rapid test. It requires 400,000 initial investment to start the project. It is expected that this project will bring 115,000 annual revenue for the next 4 years.

Following the MM Proposition I & II, calculate the market value and the required rate of return of PharmaTechs share of the unlevered and levered position before the repurchase transaction. Assume NO corporation tax.

Current (Unlevered - U) 15,000 15,000 0 Assets Equity Debt Debt-to-equity ratio Share outstanding Share price Interest rate on debt Figures in thousands Proposed (Levered - L) 15,000 9,000 6,000 0.67 120.0 75.00 5.096 200 75.00