Taft Manufacturing is currently a levered firm with 15M shares outstanding priced at $30.00 per share and 350K bonds outstanding priced at $1,000 per bond (this is also the face value of each bond). Investors expect these bonds to pay interest of 5 percent per year (this is also the expected return for these bonds) and this debt level to be held in perpetuity. Assume that Taft is subject to a 35 percent corporate tax rate.
a) Taft’s assets consist of its operating assets and tax shield. Calculate the value of the tax shield, and then calculate the value of the operating assets.
Taft announces that tomorrow it will issue $150M worth of shares and use those funds to retire $150M worth of debt. Assume that the market did not expect this announcement, and is certain that Taft will follow through with this recapitalization.
b) What is the new price per share immediately following this announcement, but before the shares are issued or the debt is retired? (hint: the share price will decrease because of a change in the value of the tax shield)
c) Following the announcement, what percentage of the firm’s equity does Taft have to sell to raise $150M?
d) Suppose instead that the market believes there is a 10 percent probability that Taft will not follow through with the recapitalization tomorrow and a 90 percent probability that the recapitalization will happen, as per the announcement. Given this belief, what is the new price per share following the recapitalization announcement?
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