15. Suppose that the capital market is perfect and there are no taxes. Consider an all- equity firm with 1000 equity shares outstanding. The stock price is $10. Thus, the market value of equity is $10,000, which equals the market value of the firms assets.

    The firm is considering changing its capital structure by issuing $5000 of par bond at 10% interest rate to buy back 500 equity shares.

    Assume that there are four possible scenarios of economy/operating income: $500, $1000, $1500, $2000,

    1. What is the effect of this change on the firm value?

    2. What is the effect of this change on the risk of the firms equity?

    3. What is the effect of this change on the risk of the firm?

    4. What is the effect of this change on the firms cost of capital?

    Assume an operating income of $1500,

    5. What are the effects of this change on the firm value and on the expected return on equity

       if there are corporate taxes and the tax rate is 35%?

    6. Suppose that the debt is permanent (i.e., the company always keeps the same amount of

       debt in the company), what is PV (tax shield)?

    7. With taxes, will firm value change after the refinancing?

    8. Suppose that T_P=0.35, T_PE=0.15, T_C = 0.35, what is the effect of personal taxes on

       interest tax shield?