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Keenan Corp. is financed entirely by common stock. The firm is expected to generate a level, perpetual stream of earnings and dividends. The current share price is $50 and its stock beta is 0.75.
Suppose the firm decides to repurchase half of its shares and substitute an equal value of debt. The debt is risk-free, with a 5 percent interest rate. The company is exempt from corporate income taxes. The stock index returns averaged 15 percent per annum the last 10 years.
Assume that the Miller and Modigliani (1958) Model applies.
Problem 1: Compute the cost of equity of Keenan Corp. before taking on debt
Problem 2: Compute the cost of equity of Keenan Corp. after taking on debt and explain the difference in your answer here and in part (a).
Problem 3: What is the stock price after taking on debt and compare with the share price before taking on debt
Problem 4: Briefly discuss Keenan Corp's optimal capital structure using Miller and Modigliani's modified model
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