An unlevered firm has perpetual cash flows, equity beta of 1.5, 1 million shares (P=$20). Rf = 9%, Tax rate=40%, MRP=5.5%. It is considering issuing debt and using the proceeds to repurchase equity.
D/(D+E) 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Rd 10.5% 11% 12% 13% 14% 16% 18% 20% 25%
a) What is the optimal capital structure?
b) Can you assess the change in firm value as a result of this decision?