Capital Structure

Pennewell Publishing Inc. is a zero growth company. It currently has zero debt and its earnings before interest and taxes are $90,000. PP's current cost of equity is 10%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48,000.

a) PP is considering changing its capital structure to one with 30% debt and 70% equity, based on market values. The debt would have an interest rate of 5%. The new funds would be used to repurchase stock. It is estimated that the increase in risk resulting from the added leverage would cause the required rate of return on equity to rise to 12%. If this plan were carried out, what would be PP's new value of operations?

b) Now assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity. This results in a weighted average cost of capital equal to 9% and a new value of operations of $600,000. Assumer PP raises $200,000 in new debt and purchased T-bills to hold until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase?

c) Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity. This results in a weighted average cost of capital equal to 9% and a new value of operations of $600,000. Assume PP raises $200,000 in new devt and purchase T-bills and uses the proceeds to repurchase stock. How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase?