Consider a world of perfect capital markets. This world has no corporate or personal taxes, all investors have homogeneous expectations, no bankruptcy costs, and M&M's no-tax theory of capital structure is true.
Company Y is financed has the following market value balance sheet:
Assets = $450 Liabilities = $210
Equity = $240
The firm had $27.00 in EBIT last year. The firm has 30 shares outstanding. The firm expects this same return for the foreseeable future. The firm is a zero growth firm, that pays out all excess earnings as dividends. Any time the firm changes its capital structure, it changes only the debt/equity mix and does not change its total assets. The firm's liabilities consists entirely of perpetual debt. The firm's debt is risk-less, selling at par, and has a 3% yield. If the firm were to change its capital structure, new debt would still have a 3% yield. The expected return on the market portfolio is 8.0%. Given this information, answer the following questions:
a. What is the firm's return on equity?
b. What is the firm's current weighted average cost of capital.
c. What is the current stock price per share?
Now assume that the above firm issues enough equity to repurchase all of the firm's debt. This change in capital structure reveals no new information about future firm prospects.
d. Write out the firm's new balance sheet.?
e. What is the firm's new stock price?