a) Consider a company that operates in a world with perfect capital markets (including no taxation), and is financed entirely by equity with a market value of $2.5 million. The annual net operating income (NOI) of the company is $500,000.

The company is planning to buy back a substantial part of its own shares from its shareholders at the current market value of its shares. The buyback is to be funded entirely by the proceeds of a corporate bond issue. After the bond issue and buyback the company expects to have an equal amount of debt (D) and equity (E), i.e., D/E = 1.

Required:

i. Calculate the rate of return on equity given the present capital structure (all equity). Briefly explain your method and result.

ii. Calculate the rate of return on equity following the proposed capital-structure change assuming that (at the new D/E ratio) it faces a cost of debt of 10 percent. Briefly explain your method and result, and comment on your assumptions.

iii. Suppose the company increased its ratio of debt to equity further. How do you expect its cost of debt, cost of equity, and its weighted average cost of capital to change?

b) Explain and critically discuss whether the prospect of financial distress and its associated costs affect the financing decisions of companies in the real world.