There is no tax (corporate tax rate = income tax rate = capital gain tax = 0%). Everyone

is risk-neutral, and the risk-free rate is 3%.

Firm F has 100,000 outstanding stocks, and $1 million in cash. Debt has face value 1.5 million, matures in one year, and has a coupon equal to 6%. EBIT in one year is expected to be either $1 million or $3 million with equal probability.

Firm F wants to do a share repurchase immediately in year 0, and has the choice between paying out 30% or 70% of its cash in the process (no other option available).

Investors will invest the cash they receive at time 0 at the risk-free rate (i.e., if they invest 5 in year 0, they receive 5*1.03 in year 1). The cash that is retained by the firm can be invested at a superior rate (called internal rate) equal to 7%.

1. Will shareholders choose to pay out 30% or 70% of the cash of the firm?

2. What is the maximum internal rate such that shareholders prefer to pay out 70% of the cash of the firm?

3. How many shares would have to be issued in each payout scenario (not accounting for decimals)?

4. Assume that debtholders actually have implemented a covenant preventing firm F from paying out more than 40% of the cash of the firm. Computing the value of debt under the two scenarii, find the value of the covenant. Based on your previous answers, could you have computed it in another way? Using which tool covered in the course?