Midnight and Moonlight (M&M) Corporation’s earnings before interest and taxes are $8,000,000 each year. The company currently has no debt, but is considering issuing $20,000,000 of debt with 10% interest payments. It will use the proceeds to buy back equity. M&M has a 100-percent payout policy. Assume that the corporate tax rate is 40% and that M&M’s earnings and debt are perpetual.
a. Which plan offers the highest cash flows for investors?
b. Suppose the shareholders originally demand 12% return on equity. What is the value of the firm under each plan?
c. How has the return on equity changed under the plan with debt financing?
d. What is the new weighted average cost of capital?