1. You are in a perfect capital market setting. As CFO of XYZ Corporation, you are asked to comment on how you can reduce the firm's weighted average cost of capital. You explain that all you have to do is issue debt and use the proceeds from the debt issue to repurchase equity. Since debt is less costly than equity the WACC will decline, causing the value of the firm to go up. The firm is worth $ 80 million, and the cost of capital is 20%. There is 50% debt in the capital structure, and the cost of debt is 3% (explain all answers fully):
a. Find the cost of equity.
b. What is the Value of the Debt, and Value of the Equity to this firm?
c. If the firm issues $20 million in new equity, and uses the proceeds to repurchase debt, how will the value of the firm change as a result of this capital structure change?
d. What will the new cost of equity be if the cost of debt doesn't change?
e. What happens to stockholders' wealth as a result of this capital structure change (explain fully)
2. We have discussed three basic theories of capital structure (irrelevance, pecking order, and static tradeoff).
a. What is the difference in the way managers will behave regarding their capital structure decisions in each of these theories. Explain fully.
b. Describe in detail how the static tradeoff theory works and what management will consider when making the capital structure decision in this context.
3. Draw graphs of the expected abnormal price movements (if any) over a 5 day period before, on the announcement date, and a 5 day period after the following unanticipated announcements or events given the form of market efficiency assumed, and that the firm is traded on the New York Stock Exchange located in the Eastern Standard Time Zone (After hours trading is limited to 4:00 to 6:30 PM Eastern Standard Time). Explain fully
(i) A firm announces a stock repurchase when the stock market is open and markets are semi-strong form efficient
(ii) A firm announces a dividend increase and markets are strong from efficient
(iii) The firm announces the CEO had a heart attack on his 80th birthday (11 pm Eastern Standard Time yesterday) and markets are strong form efficient.
(iv) The firm announces unusually strong earnings and a large dividend increase and markets are semi strong form efficient.
(v) You observe an unusual run up in the stock price in the previous week and the market is weak form efficient