Problem:

A firm is currently an all equity firm with 1 million shares outstanding and a stock price of $10. The firm is contemplating selling $1 million in bonds and using the proceeds to repurchase shares. The current expected return on the firm's stock is 20% and the bonds would offer investors a 10% expected return. In all of the scenarios below, the combined financial distress and agency costs associated with debt financing are equal to 2% of the value of the debt issued.

Requirement:

Question 1: If the corporate tax rate is 40% and personal tax rates on income and capital gains are 0, what will the value of the firm be after the repurchase assuming the firm intends to maintain the $1 million in debt forever (i.e., in perpetuity).

Question 2: If the corporate tax rate is 40%, the effective personal tax rate on equity income (TE) is equal to 0, and the tax rate on interest income (TD) is equal to 40%, what will the value of the firm be after the repurchase assuming the firm intends to maintain the $1 million in debt forever (i.e., in perpetuity).

Note: Please show guided help with steps and answer.