Evaluation of various capital structure mix.

What remains to be seen, however, is whether shareholders are better or worse off with more leverage. Problem 2 does not tell us because there we computed total value of equity, and shareholders care about value per share. Ordinarily, to value will be a good proxy for what is happening to the price per share, but in the case of a relevering firm, that may not be true. Implicitly, we assumed that, as our firm in problems 1-3 levered up, it was repurchasing stock on the open market Debt tax shields can be valued by discounting the future annual tax savings at the pretax cost of debt. For debt, that is assumed to be outstanding in perpetuity, the tax saving is the tax rate. t. times the interest payment, k X D. The present value of this perpetual savings is tkD/k = tD.

Now, solving for the price per share may seem impossible because we are dealing with two unknowns-share price and the change in the number of shares: