Problem #3: 25 points - Capital Structure Lew D. Chris, Inc. presently has no debt. In an effort to combat a takeover bid, they propose to retire some of their outstanding stock with the issuance of long-term debt. Michael Milkman of We'll Getcha & Burnya puts forth a plan that not only retires some of the outstanding stock of the company, but at the same time, suggests that the move will increase the value of the company. Milkman's methodology for calculating the value of the firm does not employ the theoretical proposition of value enhancement through MM's "present value of the interest tax shield, but rather a more intuitive model. Presently the company has 250,000 shares outstanding with a market price of $20.00 per share. Investors have priced the unlevered stock on the basis of 1.20 Beta, a UST Bond of 5.2%, and an equity risk premium of 4%. Milken proposes the issuance of $1,000,000 of 7% debentures. Given a tax rate of 40%, an expectational D/E ratio of 25%, and the assumption that all earnings are paid out in dividends...you may consider that the Beta of debt =0. Required: 1) what effect would this strategy have on the value of the firm? 2) how many shares of stock would be retired? 3) what is the firm's EPS before and after the stock retirement? 4) prove your conclusions by establishing the firm's overall cost of capital Problem #3: 25 points - Capital Structure Lew D. Chris, Inc. presently has no debt. In an effort to combat a takeover bid, they propose to retire some of their outstanding stock with the issuance of long-term debt. Michael Milkman of We'll Getcha & Burnya puts forth a plan that not only retires some of the outstanding stock of the company, but at the same time, suggests that the move will increase the value of the company. Milkman's methodology for calculating the value of the firm does not employ the theoretical proposition of value enhancement through MM's "present value of the interest tax shield, but rather a more intuitive model. Presently the company has 250,000 shares outstanding with a market price of $20.00 per share. Investors have priced the unlevered stock on the basis of 1.20 Beta, a UST Bond of 5.2%, and an equity risk premium of 4%. Milken proposes the issuance of $1,000,000 of 7% debentures. Given a tax rate of 40%, an expectational D/E ratio of 25%, and the assumption that all earnings are paid out in dividends...you may consider that the Beta of debt =0. Required: 1) what effect would this strategy have on the value of the firm? 2) how many shares of stock would be retired? 3) what is the firm's EPS before and after the stock retirement? 4) prove your conclusions by establishing the firm's overall cost of capital
