Problem 3 (MM fallacies: Leverage and share prices)

Assume that Rose Corporations (RC) EBIT is not expected to grow in the future and that all earnings are paid out as dividends. RC is currently an all-equity firm. It expects to generate earnings before interest and taxes (EBIT) of $6 million over the next year. Currently, RC has 5 million shares outstanding and its stock is trading for a price of $12 per share. RC is considering borrowing $12 million at a rate of 6% and using the proceeds to repurchase shares at the current price of $12.

(c) Following the borrowing of $12million and subsequent share repurchase, the number of shares that RC will have outstanding is closest to:

(1) 4.0 million (2) 6.0 million (3) 4.9 million (4) 4.5 million