3. Executive Chalk is financed solely by common stock and has outstanding 25 million shares with a market price of $10 a share. It now announces that it intends to issue $160 million of debt and to use the proceeds to buy back common stock.
a. How is the market price of the stock affected by the announcement?
The market price of the stock is not affected by the announcement
b. How many shares can the company buy back with the $160 million of new debt that it issues?
Since the market price of the shares is $10, the company can buy back:
$160 million/$10 = 16 million shares
c. What is the market value of the firm (equity plus debt) after the change in capital structure?
After the change in capital structure, the market value of the firm is unchanged:
Equity + Debt = (9 million ´ $10) + $160 million = $250 million
d. What is the debt ratio after the change in structure?
After the change in structure, the debt ratio is:
Debt/(Debt + Equity) = $160 million/$250 million = 0.64
e. Who (if anyone) gains or loses? Now try the next question.
No one gains or loses
13. Omega Corporation has 10 million shares outstanding, now trading at $55 per share.
The firm has estimated the expected rate of return to shareholders at about 12 percent.
It has also issued long-term bonds at an interest rate of 7 percent. It pays tax at a marginal rate of 35 percent.
a. What is Omega’s after-tax WACC?
E = $55 ´ 10 million = $550 million
V = D + E = $200 million + $550 million = $750 million
After-tax WACC =
b. How much higher would WACC be if Omega used no debt at all? Hint: For this problem you can assume that the firm’s overall beta (_A) is not affected by its capital structure or the taxes saved because debt interest is tax-deductible.
As indicated in Table 17.4 in the text, the after-tax WACC would increase to the
extent of the loss of the tax deductibility of the interest on debt. Therefore, the
after-tax WACC would equal the opportunity cost of capital, computed from the
WACC formula without the tax-deductibility of interest: