Question
UnLever Co. and Lever Co. are two identical companies in all aspects except for their capital structures. UnLever Co. is an all-equity-financed company, with total
UnLever Co. and Lever Co. are two identical companies in all aspects except for their capital structures. UnLever Co. is an all-equity-financed company, with total market value $600,000; whereas Lever Co.'s capital structure contains both stock and perpetual coupon-only bond with annual coupons $18,000. Yield-to-maturity is 9%. Both companies' EBIT is $75,000. Assume no taxes, and lending rate = borrowing rate.
a). What is the market value of Lever Co.'s perpetual bond? What is the Debt-to-Equity ratio of Lever Co. ?
An investor holding $30,000 of Lever's stocks want to mimic the exact cash incomes and ROE as holding unLever's stocks. The investor can borrow at the same 9% interest rate (i.e. homemade leverage).
b). What is the ROE of unLever Co. and Lever Co. ? How the investor can generate the exact cash incomes and ROE as the Lever Co.'s stocks ? (ps:This question is the most important)
Now suppose that the tax rate is 30% and Lever Co. has 10,000 shares outstanding. Further assume that the company wants to reduce the debt level to $100,000 by issuing new shares. The company still generates EBIT $75,000.
c). What is the firm value (sum of debt and equity) of Lever Co. before and after the reduction of debt level? How many shares the company should issue? (Assume the company can issue non-integer numbers of shares.) Other things being held equal, is it wise for Level Co. to reduce its debt level and why? In real world, suggest two potential motivations for a firm to reduce debt level?
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