Executive Cheese has issued debt with a market value of $200 million and has outstanding 30 million shares with a market price of $10 per share. It now announces that it intends to issue a further $120 million of debt and to use the proceeds to buy back common stock. Debt holders, seeing the extra risk, mark the value of the existing debt down to $140 million. Given this information, answer the following five questions (assume no taxes).
a) How is the market price of the stock affected by the announcement? Justify your response (hint: Calculate the actual change in the price of stock) .
b) How many shares can the company buy back with the $120 million of new debt that it issues?
c) What is the market value of the firm (equity plus debt) after the change in capital structure?
d) What is the debt ratio after the change in capital structure?