Question 2 The firm Direc has 24 million equity shares whose current market price per share is 9.84, and no debt. The firms annual cash flow, before interest and tax, is 21.2 million and this is expected to remain constant in future. All earnings are paid out as dividends. The corporation tax rate is 20%. The market is semi-strong form efficient.

(a) What is Direcs cost of equity (return on equity), and its weighted average cost of capital? (4 marks)

Assume now that the managers of Direc decide to change the firms capital structure, by raising 36.5 million in debt finance which will all be used to repurchase a number of equity shares. The annual interest rate of the debt will be 5%

(b) As soon as the plan has been announced, but before the restructuring has happened, what will Direcs share price be, and why? (4 marks)

(c) How many shares will be repurchased in the restructuring, and how many will remain? (4 marks)

(d) After the restructuring, what will be the firms earnings per share and cost of equity (return on equity)? (6 marks)

(e) What is Direcs weighted average cost of capital after the restructuring? Does this differ from your result in part (a)? Explain the reasons why/why not.