Trident Corporation is currently worth $16 million. Its current debt-to-value (D/V) ratio is 60%. 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 firms debt value is expected to rise by $1.4 million. The cost of debt is 8 percent per year. Trident expects to have an EBIT of $2.4 million per year in perpetuity. Tridents tax rate is 30%.
(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 firms 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 firms equity after the announcement?
(d) How much does the value of the firm increase after the announcement? If the goal is to maximize the firms value, would you recommend the CEO of Trident to borrow as much as they can? Please explain your rationale. Ignore the cost of financial distress and agency cost.
(e) Now we consider the downside of debt borrowing: cost of financial distress and agency cost. The more debt there is, the more costly it could be when the firm fails to meet its debt obligation. Suppose the firm expects to incur an additional cost of $360,000 for this $1.4 million increase in leverage. If the goal is to maximize the firms value, would you recommend the CEO of Trident to proceed with this repurchase plan? Please explain your rationale.