Question
The Perpetual Motion Machine. is assessing its current capital structure and its implications for the welfare of its security holders. Perpetual is currently nanced entirely
The Perpetual Motion Machine. is assessing its current capital structure and its implications for the welfare of its security holders. Perpetual is currently nanced entirely with common stock, of which 100,000 shares are outstanding. Given the risk of the underlying free cash ows generated by Perpetual Motion, investors currently require a 23% return on the Perpetuals common. Perpetual Motionss expected free cash ows are $2.4 million next year expected to grow at 3% per year in perpetuity and it faces a corporate tax rate of 35%. The market risk-premium is 6% and the risk-free rate is 5%. (a) What is the value of Perpetual Motion, its equity value, the beta of its equity? [6 points]
(b) The CEO of Perpetual has re-evaluated its capital structure and has come to the conclusion that it has debt capacity of $6 million. The proceeds of the debt issue will be used to repurchase equity. Assuming the cost of this debt is 6%, and the debt level will be constant in perpetuity, what is the new value of the rm and the value of its equity? [7 points]
(c) Using the data of the previous parts and assuming that the market agrees with the CEOs assessment of Perpetuals debt capacity, what will be the eect of the announcement of the capital structure change on Perpetuals stock price? How many shares will be bought back and how many will be left outstanding? [8 points]
(d) Still using the data of previous parts, what is the eect of the capital structure change on Perpetuals equity beta and expected return on equity? [6 points]
(e) Given all the assumptions above, is it reasonable to also assume that Perpetuals expected cost of debt will remain constant over time? Why or why not? No computations necessary, a verbal answer will su ce. [3 points]
Relevant formulas and explanations would be greatly appreciated, thanks in advance
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