Divido Corporation is an all-equity financed firm with a total market value of $100 million. The company holds $10 million in cash-equivalents and has $90 million in other assets. There are 1,000,0000 shares of Divido common stock outstanding, each with a market price of $100. Divido Corporation has decided to issue $20 million of bonds and to repurchase $20 million worth of its stock.
a) What will be the impact on the price of its shares and on the wealth of its shareholders? Why?
b) Assume that Divido’s EBIT has an equal probability of being $20 million, or $12 million, or 4$ million. Show the impact of the financial restructuring on the probability distribution of earnings per share in the absence of taxes. Why does the fact that the equity becomes riskier not necessarily affect shareholder wealth?