Question
The Knight Corporation plans to issue $2 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par
The Knight Corporation plans to issue $2 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 6 percent. The company is currently unlevered and worth $10 million with 200,000 shares of common stock outstanding. The annual aftertax earnings of the company in the next period is expected to be $1 million, and the earnings will grow at a rate of 5 percent forever. The corporate tax rate is 21 percent.
1. What is the return on asset (ROA) for the company?
2. What is the stock price per share before the announcement of the debt issue?
3. What is the present value of tax shield (in millions) under the new capital structure?
4. What is the stock price per share immediately after the recapitalization?
5. What is the cost of equity immediately after the recapitalization?
6. What is the cost of capital immediately after the recapitalization?
7. Who benefit from the recapitalization?
a. Shareholders gain from tax shield.
b. Shareholders gain by extracting value from debtholders.
c. Both shareholders and debtholders gain from tax shield.
d. Nobody gains from the recapitalization.
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