Problem 1:
We follow the performance of the George Company with a stock that's trading for $14/share. They have 1MM outstanding shares and has $6MM in outstanding debt that yields 10% per annum. They have an EBIT of $4MM that will remain constant forever. The tax rate is 40%.
1. What is the expected return on equity before the buyback?
2. What is the new debt-equity ratio after the buyback?
3. What is the expected return on equity after the buyback?
Problem 2:
Based on the information provided, decide which of the two companies should have more debt as a fraction of the market value of the firm. Briefly describe the relevant factors in the decision.
Case A Company 1 Company 2
Book value of assets $2 billion $1 billion
Market value of equity $7 billion $500 million
Growth in earnings 19% 1%
Capital Expenditures $200 million $13 million
Case B Company 3 Company 4
Standard deviation of the 35% 60%
Annual change in operating
income