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# Stock Buy Back Decision on a Zero Growth Firm

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An short analysis (sheet) needs to be prepared using excel to decide whether the proposal should be accepted or rejected.

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You have the following data on Joe's Corporation:
EBIT: \$1,000,000
Tax rate: 40%
Cost of equity: 10%

Joe's is a zero growth firm, and is currently financed entirely with equity (in other words, it currently has no debt).
One of the corporate officers has suggested that since interest rates are so low, Joe might be better off if he borrowed some money and used it to buy back stock, thereby making use of debt financing in the firm. He presents the following data in his analysis:
Amount of debt proposed: \$1,000,000
Interest rate: 6%
New cost of equity after the money after the money is borrowed: 12%

Joe has come to you for advice. Prepare an analysis for him that indicates whether or not the proposal should be accepted.

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#### Solution Preview

See the attached file for complete solution. The text here may not be copied exactly as some of the symbols / tables may not print. Thanks
You have the following data on Joe's Corporation:

EBIT: \$1,000,000
Tax rate: 40%
Cost of equity: 10%

Joe's is a zero growth firm, and is currently financed entirely with equity (in other words, it currently has no ...

#### Solution Summary

The solution evaluates a stock buy back proposal to recommend whether it should be accepted or not in an Excel attachment.

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## Problem Set

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9-3 The values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term interest rates. Therefore, short-term bond prices are more sensitive to interest rate changes than are long-term bond prices." Is this statement true or false? Explain.

9-4 The rate of return you would get it bought a bond and held it to its maturity date is called the bond's yield to maturity. If interest rates in the economy rise after a bond has been issued, what will happen to the bond's price and its YTM? Does the length of time to maturity affect the extent to which a given change in interest rates will affect the bond's price?

9-5 If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable? Explain.

9-6 Indicate whether each of the following actions will increase or decrease a bond's yield to maturity:
a. A bond's price increases.
b. The company's bonds are downgraded by the rating agencies.
c. A change in the bankruptcy code makes it more difficult for bondholders to receive payments in the event a firm declares bankruptcy.
d. The economy enters a recession.
e. The bonds become subordinated to another debt issue.

Pages 410

10-2 The investors are evaluating AT & T's stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, they agree on the riskiness of the stock. However, one investor normally holds stocks for 2 years, while the other normally holds stocks for 10 years. On the basis of the type of analysis done in this chapter, they should both be willing to pay the same price for AT & T's stock. True or False? Explain.
10-4 If you bought a share of common stock, you would typically expect to receive dividends plus capital gains. Would you expect the distribution between dividend yield and capital gains to be influenced by the firm's decision to pay more dividends rather than to retain and reinvest more of it's earning?

Mini Case Page 415

a. Describe briefly the legal and privileges of common stockholders.
b. 1. Write out a formula that can be used to value any stock, regardless of its dividend pattern.
2. What is a constant growth stock? How are constant growth stocks valued?
3. What happens if a company has a constant g, which exceeds its ks? Will many stocks have expected g > ks in the short run (i.e. for the next few years)? In the long run (i.e., forever)?

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