Question 3 (20 marks)

Freedom Corporation is considering to repurchase part of its common stock by issuing bonds and consequently the debt-equity ratio of the firm will increase from 35% to 50%. The current market value of the firms debt is $2.7 million, and the cost of debt is 6.4%. The EBIT of the firm is expected to be $940,000 in perpetuity. Assume there are no taxes.

(a) What is the market value of the firm before and after the stock repurchase? Explain. (9 marks)

(b) Calculate the expected return on the firms common stock before the stock repurchase. (3 marks)

(c) Calculate the expected return on the common stock of an otherwise identical all-equity firm. (4 marks)

(d) Calculate the expected return on the firms common stock after the stock repurchase. (4 marks)