You work for Microsoft. Your boss asks you to evaluate the firms capital structure. Microsoft currently has a market value of $200 billion and no long-term debt outstanding. You forecast that the firm will earn $10 billion next year and will generate cashflows of $8 billion after all investments have been made. The forecasts are accurate to within +/ $1.2 billion. The firms marginal tax rate is 40%.

(a) Microsoft is thinking about issuing $30 billion in corporate bonds. It will use the proceeds from the sale to repurchase equity. How will this transaction affect the riskiness of the firms equity? Why? (10)

(b) If Microsoft decides to have a leverage recapitalization, how will the stock market react to this transaction? Why does the market react this way?(10)

(c) The interest rate on the new debt is 7% and Microsoft plans to roll-over this debt in perpetuity (issue new debt for the same amount and same rate when the old debt matures). How much does the debt add to Microsofts value? (10)

(d) Microsoft currently has a 14% cost of capital. After the leverage recapitalization, will Microsofts cost of capital be higher, lower, or the same? Why? (10)