Problem: Company A and B are two identical companies with equal asset values of $50 million. Company A is financed by equity only and has 100,000 shares outstanding. Company B has perpetual risk-free debt in its capital structure with a market value of $20 million. Company B also has 100,000 shares outstanding. The risk-free rate is 1%.
(1) Assume that there are no taxes. What is A's share price? What is B's share price?
(2) Can you create a portfolio that mimics the risk-return profile of Company A (1 stock of Company A) and consists of the risk free asset and Company B's stock? If yes, describe the portfolio.
(3) Company B wants to achieve its long-term target Debt-to-Equity ratio of 0.5. How much debt or equity does Company B have to buy back? Calculate the value of the debt and equity after the buy-back.
(4) Let's consider that the corporate tax rate is 35% (assume that the levered value of Company B is still $50 million). Analyze the scenario in part (3) with corporate tax rates. What is the value of debt and equity after the buy-back in part (3).
(5) Why are the market values of debt and equity different in parts (3) and (4)?