Problem
A firm has equity with market value $100 million and debt with market value at $70 million.
The debt pays perpetual expected coupons of $3.5 million annually.
The above numbers are prior to a stock buyback being announced.
The firm uses some of its cash buyback stock on of $20 million. As a result of the fall in its cash, the expected coupon payment to debt reduce to $3.4 million (expected payments is the probability weighted future coupons, and the probability that in some future states of the world the firm would default has increased due to the the stock buyback). Also the rate of discount Rd for expected coupons paid to debt rises to 5.20%.
Assume Modigliani-Miller is true (which also means there are no taxes).
What will be the value of Equity after the stock buyback?