Suppose the risk free rate is 2.5%, and the expected return on the market is 9%. In GM’s Value Line Report, GM’s market value of equity is 27.6 billion, they have 0.450 billion shares outstanding, and the market value of debt is 159 billion. Suppose GM were to replace $25 billion of debt by issuing $25 billion of equity (and that this swap would be in perpetuity). Assume that GM has a beta of 1.3, a tax rate of 20%, and a cost of debt equal to 8%.
a. What is the total value of GM before the swap?
b. What is the expected return on equity before the swap?
c. What would the value of debt, equity, and the total value of GM be after the swap? REMEMBER – VL = VU + PV(tax shields)
d. In one sentence tell me why the expected return to shareholders has changed.