The NEWT Company is located in a country where there are no taxes and there are perfect capital markets so that there are no bankruptcy costs. The corporation currently has $25 million in debt outstanding and the value of its equity is $75 million. The return on its equity is 15% and the return on debt, which is currently risk free is 8%. Suppose NEWT decided to issue $15 million additional debt and use it to repurchase $15 million of equity. The new debt is expected to be risk free after the issue. All the debt, both before and after the refinancing, consists of perpetuities.
A. What is the total value of the firm after the refinancing?
B. What would the return on equity be after the refinancing?
C. Now lift the assumption of no corporate tax and assume that the corporate income tax is 40%. How does the existence of corporate income tax affect the market value of the firm as computed in question (a)? (Assume that the tax doesn’t change the original firm value before the refinancing, which was $100 million)
D. If bankruptcy risk were a concern with this level of debt, how would it qualitatively affect your answer in question (C)