Union brick inc. has a total market value of $200 million, consisting of 2 million shares of common stock selling for $50 per share and $100 million of 10% perpetual bonds currently selling at par. UBI pays out all earnings as dividends, and its marginal tax rate is 40%. The firm’s earnings before interest and taxes (EBIT) are $30 million. Management is considering increasing UBI’s debt to $140 million by calling in all the old bonds and issuing new debt with a 12% coupon which sells at par. The additional funds will be used to repurchase stock at the new equilibrium price. If UBI’s financial leverage is increased as described, the required rate of return on common equity will increase to 15%
a) What is UBI’s current required rate of return on equity?
b) What would be the value of the firm in the capital structure change were made?
c) Regardless of your answer to the previous question, assume the value of the firm would be $204 million if the capital structure change were made. What would be the new stock price?