1. Green Manufacturing, Inc., plans to announce that it will issue $2 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 6 percent. Green is currently an all-equity firm worth $6.3 million with 400,000 shares of common stock outstanding. After the sale of the bonds, Green will maintain the new capital structure indefinitely. Green currently generates annual pretax earnings of $1.5 million. This level of earnings is expected to remain constant in perpetuity. Green is subject to a corporate tax rate of 40 percent.
a. What is the expected return on Green’s equity before the announcement of the debt issue?
b. Construct Green’s market value balance sheet before the announcement of the debt issue. What is the price per share of the firm’s equity?
c. Construct Green’s market value balance sheet immediately after (upon) the announcement of the debt issue.
d. What is Green’s stock price per share immediately after (upon) the repurchase announcement?
e. How many shares will Green repurchase as a result of the debt issue? How many shares of common stock will remain after the repurchase?
f. Construct the market value balance sheet after the restructuring.
g. What is the required return on Green’s equity after the restructuring?
2. Williamson, Inc., has a debt-equity ratio of 2.5. The firm’s weighted average cost of capital is 10 percent, and its pretax cost of debt is 6 percent. Williamson is subject to a corporate tax rate of 35 percent.
a. What is Williamson’s cost of equity capital?
b. What is Williamson’s unlevered cost of equity capital?
c. What would Williamson’s weighted average cost of capital be if the firm’s debt-equity ratio were .75? What if it were 1.5?