You own all the equity of Space Babies Diaper Co. The company has no debt. The company?s annual cash flow is $900,000 (perpetuity) before interest and taxes. The corporate tax rate is 35%. You have the option to exchange equity for 5% bonds worth $2,000,000. Assume you have 1 million shares and return on equity is 10% before recapitalization. For Question 1 and Question 2 find all the parameters below, but pay special attention to the value of the unlevered and levered firm (V_u, V_l), cost of equity for unlevered and levered firm (Re_u, Re_l) and weighted average cost of capital for the unlevered and levered firm (WACC_u, WACC_l) before and after the recapitalization!!!

SpaceBabies Diapers Homework You own all the equity of Space Babies Diaper Co. The company has no debt. The company's annual cash flow is $900,000 (perpetuity) before interest and taxes. The corporate tax rate is 35%. You have the option to exchange equity for 5% bonds worth $2,000,000. Assume you have 1 million shares and return on equity is 10% before recapitalization. For Question 1 and Question 2 find all the parameters below, but pay special attention to the value of the unlevered and levered firm (Vu, Vl), cost of equity for unlevered and levered firm (Reu, Rel) and weighted average cost of capital for the unlevered and levered firm (WACC u, WACCl) before and after the recapitalization!!! Q1: Assume there are no taxes and bankruptcy costs (M&M Case I) Q2 Assume taxes exist but there are no bankruptcy costs (M&M Case II) Q3: What happens to the firm's share price at the announcement of the debt issue? At recapitalization? EBIT = $900,000 1 million shares Re =10% Bonds $2,000,000 Rd=5% Vu E D WACC PPS Vl PPS@ann. Shares bought Shares left D E PPS after recap. D/E Re WACC T= 35% Case I (no tax, no bankruptcy cost) VL = VU Vu = EBIT / RA Value of the levered firm is same as the value of unlevered RE = RA + (RA - RD)*(D/E) WACCL = (E/V)*RE + (D/V)*RD WACC = RA WACC is constant Case II (corporate tax, no bankruptcy cost) VL = VU + D*TC Vu = EBIT*(1T)/RA Value of the levered firm is higher than unlevered by PV of annual interest tax shield RE = RA + (RA - RD)(D/E)(1TC) WACCL = (E/V)*RE + (D/V)*RD*(1TC) WACC declines as D/E increases RECAPITALIZTION