a) Martin & Sons (M&S) currently is an all equity firm with 40,000 shares of stock outstanding at a market price of $25 a share. The company’s earnings before interest and taxes are $80,000. M&S has decided to add leverage to their financial operations by issuing $500,000 of debt with a 7 percent interest rate. This $500,000 will be used to repurchase shares of stock. You own 1,000 shares of M&S stock. M&S has a 100% dividend payout ratio, implying that all earnings are paid out to the shareholders.

Assume that you can also borrow and lend at 7%.

i. What is your dollar earning when M&S is unlevered?

ii. If you want to have the same dollar earning after M&S gets levered, what should you do?

b) How does asymmetric information explain the negative stock price reaction to the announcement of an equity issue?

c) You own 1,000 shares of Yahoo Inc. You will receive a $3.40 per share dividend in one year. In two years, Yahoo will pay a liquidating dividend of $55 per share. The required return on Yahoo is 18 percent. What is the current stock price? If you wish to have equal dividends in each of the next two years, show how you can accomplish this by creating homemade dividends. Assume dividends as annuity.

d) Explain how corporate taxes affect the decision of a firm to retain excess cash?