Problem 23. MM Proposition No Taxes

Locomotive Corporation is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firms debt-equity ratio is expected to rise from 35% to 50%. The firm currently has $3.6 million worth of debt outstanding. The cost of debt is 8 percent per year. Locomotive expects to have an EBIT of $1.35 million per year in perpetuity. Locomotive pays no taxes.

1). What is the market value of Locomotive Corporation before and after repurchase announcement?

2). What is the expected return on the firms equity before announcement of the stock repurchase plan?

3). What is the expected return on the equity of an otherwise all-equity firm?

4). What is the expected return on the firms equity after the announcement of the stock repurchase?