Question 7 (13pt)

A firm is 100% equity financed and has 10 million shares. Its current share price is $50. To reduce its corporate tax, it decided to lever-up its capital structure. So today, it announced to the public that it will borrow 150 million from a bank and this debt will be permanent. And it also announced that it will use the proceed to repurchase stocks. Tax rate is 35%. Assume debt is riskless.

1. (a)Assume corporate taxation is the only friction.
2. What is firm value after this announcement? (3pt)
3. What would be the share price after this announcement? (2.5pt)
4. (b)Assume corporate taxation and financial distress cost are the only frictions. Financial distress cost takes following form:

2( ) = 0.00107 ,

= ,

= ,

1. What is the level of debt that maximizes firm value? (2.5pt)
2. What is firm value with optimal debt level? (2.5pt)
3. What would be the share price after announcement? (2.5pt)

0 500 > 500

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