QUESTION 3

ANSWER ALL PARTS OF THIS QUESTION

1. The number of outstanding shares of the all-equity company ABC is 15 million, priced at 9 per share. The company intends to announce that 30 million will be borrowed and used for a share repurchase. Interest will be paid on this debt, without plans to change the amount of debt. The corporate tax rate is 40%.

Required:

1. Calculate the market value of the companys existing assets prior to the announcement.

[2 marks]

ii. Calculate the market value of the companys assets in the moment after the debt issuance and before the share repurchase, accounting also for tax benefits.

[2 marks]

iii. Calculate the price share prior to the repurchase, and the number of shares to be repurchased.

5. marks]

iv. Calculate the market value balance sheet and share price after the share repurchase.

6. marks]

2. Explain the concept of homemade leverage.

[5 marks]

3. Discuss the trade-off theory of capital structure.

[24 marks]

4. Company DEF has eight million shares outstanding, priced at 20 per share. The company is considering two options for the 40 million of cash it has: (1) immediately pay a special dividend of 5 per share, or (2) make a risk-free investment at a rate of 8%, and use the earned interest to increase the regular dividend by 0.4 per share. Assume capital markets are perfect.

Required:

1. Suppose DEF chooses the first option. Describe how a shareholder who prefers the second option can create it herself.

[3 marks]

2. Suppose DEF chooses the second option. Describe how a shareholder who prefers the first option can create it herself.

[3 marks]

TOTAL: 50 MARKS

QUESTION 3 ANSWER ALL PARTS OF THIS QUESTION a. The number of outstanding shares of the all-equity company ABC is 15 million, priced at 9 per share. The company intends to announce that 30 million will be borrowed and used for a share repurchase. Interest will be paid on this debt, without plans to change the amount of debt. The corporate tax rate is 40%. Required: i. Calculate the market value of the company's existing assets prior to the announcement. [2 marks] ii. Calculate the market value of the company's assets in the moment after the debt issuance and before the share repurchase, accounting also for tax benefits. [2 marks] iii. Calculate the price share prior to the repurchase, and the number of shares to be repurchased. [5 marks] iv. Calculate the market value balance sheet and share price after the share repurchase. [6 marks] b. Explain the concept of homemade leverage. [5 marks] C. Discuss the trade-off theory of capital structure. [24 marks] d. Company DEF has eight million shares outstanding, priced at 20 per share. The company is considering two options for the 40 million of cash it has: (1) immediately pay a spe dividend of 5 per share, or (2) make a risk-free investment at a rate of 8%, and use the earned interest to increase the regular dividend by 0.4 per share. Assume capital markets are perfecte Required: i. Suppose DEF chooses the first option. Describe how a shareholder who prefers the second option can create it herself. [3 marks] Suppose DEF chooses the second option. Describe how a shareholder who prefers the first option can create it herself. [3 marks]