The Perpetual Motion Machine (PMM) makes toys. CEO Mr. Bundle, has maintained a conservative capital structure. PMM is 100% equity financed with 100 million shares outstanding and a market price of $10. PMM's forecasted FCFs for next year is $100 million expected to grow at 2% and its equity beta is 1. The risk -free rate is 5% and the expected market risk premium is 7%.

An activist shareholder of PMM, Ms. Bickering, has been arguing that PMM is under-leveraged. She wants PMM to maintain a 25% debt ratio. You estimate that at this level of leverage, PMM will face a credit spread of 200 basis points and that apart from the tax shield effect this change in financing policy will have negligible effects on enterprise value (e.g.transaction costs and the risk of financial distress is minimal). You have also estimated that PMM faces an effective tax rate of 20%.

Suppose Ms. Bickeringis plan is implemented. The proceeds from the new debt issue will be used to buy back shares at the market price. Assume also that the market agrees with your valuation of PMM.

(a) How much will the current shareholders of PMM gain as a result of this change in capital structure, i.e., what is the NPV of the change in financing policy?

(b) In efficient markets, what will be the effect on the share price as soon as the change in capital structure is publicly announced? What will be the share price after the capital structure change is completed? How may shares will be bought back and how many will remain outstanding?

(c) Suppose instead of a share buyback, the proceeds from the debt issue is distributed as a one time cash dividend to the current shareholders. How will your answers to parts (a) and (b) change?