Question 1:

Cornell Highways Inc (CHI) is a crown corporation (owned by the government and pays no taxes) which currently has a debt-to-equity ratio of 0.35, and $3.6 million of debt outstanding with an interest rate of 8% on debt. CHI has an EBIT of $1.35 million and expects to maintain this level of cash flows in future. CHI is looking to increase its leverage with a target D/E ratio of 0.5 by taking out debt to repurchase shares. Assuming M & M propositions with no frictions,

a) What is the value of CHI before, and after the share repurchase?

b) What is the expected return on CHI stock before the repurchase announcement?

c) What is the expected return on CHI stock if it were completely unlevered?

d) What is the expected return on CHI stock after the announcement of the repurchase plan?

e) If CHI was privatized (i.e. a private corporation, and thus subject to taxes and tax shields) would there be any advantage in moving from a D/E = 0.35 to a D/E = 0.5? Explain (no calculation required)