Question 1
You currently own 250 shares of Blue Jet Inc. Blue Jet is an all equity firm that has 36,000 shares of stock outstanding at a market price of $25 a share. The company earnings before interest and taxes are $48,000. Blue Jet Inc., has decided to issue $200,000 of debt at a 9 percent rate of interest. This debt will be used to repurchase shares of stock.
i. How many shares of Blue Jet Inc. stock must you sell to unlever your position if you can loan out funds at a 9 percent interest rate?
ii. Using the homemade leverage strategy, show that you can earn the same returns on your stock if the company decided to lever its position.
Question 2
Bruce & Co. expects its EBIT to be $85,000 every year forever. The firm can borrow at 11 percent. Bruce currently has no debt, and its cost of equity is 18 percent. If the tax rate is 35 percent,
i) What is the value of the firm?
ii) What will the value be if Bruce borrows $60,000 and uses the proceeds to repurchase shares?