Shadow, Inc., is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firm’s debt-equity ratio is expected to rise from 30 percent to 50 percent. The firm currently has $4.5 million worth of debt outstanding. The cost of this debt is 8 percent per year. Shadow expects to have an EBIT of $1.8 million per year in perpetuity. Shadow pays no taxes. (1) What is the expected return on the equity of an otherwise identical all-equity firm? (2) What is the expected return on the firm’s equity after the announcement of the stock repurchase plan?
Shadow, Inc., is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firm’s debt-equity ratio is expected to rise from 30 percent to 50 percent. The firm currently has $4.5 million worth of debt outstanding. The cost of this debt is 8 percent per year. Shadow expects to have an EBIT of $1.8 million per year in perpetuity. Shadow pays no taxes. (1) What is the expected return on the equity of an otherwise identical all-equity firm? (2) What is the expected return on the firm’s equity after the announcement of the stock repurchase plan?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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Shadow, Inc., is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firm’s debt-equity ratio is expected to rise from 30 percent to 50 percent. The firm currently has $4.5 million worth of debt outstanding. The cost of this debt is 8 percent per year. Shadow expects to have an EBIT of $1.8 million per year in perpetuity. Shadow pays no taxes.
(1) What is the expected return on the equity of an otherwise identical all-equity firm?
(2) What is the expected return on the firm’s equity after the announcement of the stock repurchase plan?
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