Problem 24. Stock Value and Leverage

Green manufacturing plan to announce that it will issue $2 million perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 6 percent. Green is currently an all-equity firm worth $6.3 million with 400,000 shares of common stock outstanding. After the sale of the bonds, Green will maintain the new capital structure indefinitely. Green currently generates annual pretax earnings of $1.5 million. This level of earnings is expected to remain constant in perpetuity. Green is subject to a corporate tax of 40 percent.

1). What is the expected return on Greens equity before the announcement of the debt issue?

2). Construct Greens market value balance sheet before the announcement of the debt issue. What is the price per share of the firms equity?

3). Construct Greens market value balance sheet immediately after the announcement of the debt issue.

4). What is Greens stock price per share immediately after repurchase announcement?

5). How many shares will Green repurchase as a result of debt issue? How many shares of common stock will remain after repurchase?

6). Construct the market value balance sheet after restructuring.

7). What is the required return on Greens equity after restructuring?