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Repurchase Stock

Green Manufacturing, Inc., plans to announce that it will issue $2 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will have a 6-percent annual coupon rate. Green is currently an all-equity firm worth $10 million with 500,000 shares of common stock outstanding. After the sale of the bonds, Green will maintain the new capital structure indefinitely. Green currently generates annual pretax earnings of $1.5 million. This level of earnings is expected to remain constant in perpetuity. Green is subject to a corporate tax rate of 40 percent.

1.What is the expected return on Green's equity before the announcement of the debt issue?
2.Construct Green's market-value balance sheet before the announcement of the debt issue. What is the price per share of the firm's equity?
3.Construct Green's market-value balance sheet immediately after the announcement of the debt issue.
4.What is Green's stock price per share immediately after the repurchase announcement?
5.How many shares will Green repurchase as a result of the debt issue? How many shares of common stock will remain after the repurchase?
6.Construct the market-value balance sheet after the restructuring. What is Green's stock price per share after the restructuring?
7.What is the required return on Green's equity after the restructuring?

Solution Preview

Please see attached file.

1. The expected return on a firm's equity is the ratio of annual after-tax earnings to the market value of the firm's equity.

Green expects $1,500,000 of pre-tax earnings per year. Because the firm is subject to a corporate tax rate of 40%, it must pay $600,000 worth of taxes every year. Since the firm has no debt in its capital structure and makes no interest payments, Green's annual after-tax expected earnings are $900,000 (= $1,500,000 - $600,000).

The market value of Green's equity is $10,000,000.

Therefore, the expected return on Green's unlevered equity is 9% (= $900,000 / $10,000,000).

Notice that perpetual annual earnings of $900,000, discounted at 9%, yields a market value of the firm's equity of $10,000,000 (= $900,000 / 0.09).

2. Green is an all-equity firm. The present value of the firm's after-tax earnings is $10,000,000 {= ($1,500,000 - $600,000) / 0.09}.

Green's market-value balance sheet before the announcement of the debt issue is:

Since the market value of Green's equity is $10,000,000 and the firm has 500,000 shares of common stock outstanding, the price of Green's stock is $20 per share (= $10,000,000 / 500,000 shares) before the announcement of the debt issue.

3. Modigliani-Miller Proposition I states that in a ...

Solution Summary

The solution explains the impact on the balance sheet of issuing debt and repurchasing stock.

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