The XYZ Co. is assessing its current capital structure and its implications for the welfare of its security holders. XYZ is currently Onanced entirely with common stock, of which 1,000 shares are outstanding. Given the risk of the underlying cash aows (EBIT, earnings

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before interest and taxes) generated by XYZ, investors currently require a 20% return on the XYZ common.

The company pays out all expected earnings as dividends to common stockholders, and these expected earnings are based on the expected operating earnings (EBIT) generated by the Ormis assets. XYZ estimates that operating income may be either 1,000, 2,000 or 4,200 with respective probabilities of 0.1, 0.4 and 0.5 depending on future economic conditions. Further, the Orm expects to produce a level stream of EBIT in perpetuity. Assume that the corporate and personal tax rates are equal to zero.

1. (a) Given the above facts, compute

   i. the value of the Orm; ii. the market value of a common share;

   iii. the expected earnings per share of common stock; iv. the Ormis average cost of capital.

2. (b) The president of XYZ has come to the conclusion that shareholders would be better o if the company had equal proportions of debt and equity. He therefore proposes to issue $7,500 of debt at an interest rate of 10% and use the proceeds to repurchase equity. Analyze this proposition by computing

3. i. the new value of the Orm; ii. the value of debt;

   iii. the value of equity; iv. the number of common shares repurchased, and the price of one such share;

   v. the required rate of return on equity; vi. the Ormis weighted average cost of capital.

4. (c) Lift the assumption of no corporate taxes and now assume that the corporate income tax rate is 40%. Assuming no risk of bankruptcy for a debt-equity ratio less than one, how does the existence of a corporate income tax aect your answers to part (b)? If bankruptcy risks were a concern, how would this (qualitatively) aect your answers?

5. (d) Now lift the assumption that personal taxes are zero. Suppose that returns to equity holders are eectively not taxed but that interest is taxed at the personal level. How will your answer to parts (c.i) to (c.iii) change if the recipients of interest on the Ormis debt are in the

   i. 30% personal income tax bracket? ii. 40% personal income tax bracket?

6. iii. 50% personal income tax bracket?