Trident Corporation is currently worth $1,000,000. Its current debt-to-value (D/V) ratio is 40%. The company is confident in meeting its debt obligation, and wants to introduce more debt to take advantage of the tax shield of interest payment. It is planning to repurchase part of the common stock by issuing more corporate debt. As a result, the firm’s debt value is expected to rise from $400,000 to $500,000. The cost of debt is 10 percent per year. Trident expects to have an EBIT of $200,000 per year in perpetuity. Trident’s tax rate is 50%.
a. What would be the market value of Trident Corporation if it were unlevered? What would be the expected return on equity if Trident were an all-equity firm?
b. What is the expected return on the firm’s equity before the announcement of the stock repurchase plan?
c. What is the value of equity after the announcement of the stock repurchase plan? How much money do the equityholders expect to receive each year under the new capital structure? What is the expected return on the firm’s equity after the announcement?