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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 (2%)? What is the Debt-to-Equity ratio of Lever Co. (2%)?
An investor holding $30,000 of Levers stocks want to mimic the exact cash incomes and ROE as holding unLevers 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. (2%)? How the investor can generate the exact cash incomes and ROE as the Lever Co.s stocks (6%).
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 (2%) and after (2%) the reduction of debt level? How many shares the company should buy back (2%)? (Assume the company can buy back non-integer numbers of shares.) Other things being held equal, is it wise for Level Co. to reduce its debt level and why (3%)? In real world, suggest two potential motivations for a firm to reduce debt level (4%)?
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