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Capital Structure and Leverage for a Locomotive Corporation

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Locomotive Corporation is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firm's debt-to-equity ratio is expected to rise from 40 percent to 50 percent.The firm currently has $7.5 million worth of debt outstanding.The cost of this debt is 10 percent per annum. Locomotive expects to earn $3.75 million per annum in perpetuity.
Locomotive pays no taxes.

a. What is the market value of Locomotive Corporation before and after the repurchase announcement?

b. What is the expected return on the firm's equity (rS) before the announcement of the stock repurchase plan?

c. What is the expected return on the equity of an otherwise identical all-equity firm (r0)?

d. What is the expected return on the firm's equity (rS) after the announcement of the stock repurchase plan?

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The solution calculates the value of firm taking into account the effect of leverage.

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Locomotive Corporation is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firm's debt-to-equity ratio is expected to rise from 40 percent to 50 percent.The firm currently has $7.5 million worth of debt outstanding.The cost of this debt is 10 percent per annum. Locomotive expects to earn $3.75 million per annum in perpetuity.
Locomotive pays no taxes.

a. What is the market value of Locomotive Corporation before and after the repurchase announcement?

Before repurchase
Value of debt= $7.50 million
Debt / Equity= 40%
Therefore value of equity= $18.75 million =7.5/40.%

Therefore, value of firm= $26.25 million =7.5+18.75

After repurchase:
Since the Corporation is not ...

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