Reference no: EM132753597

Delta plc is an all-equity firm with 50,000 shares of equity outstanding. The current price per share is £200. Delta is planning to announce that it will issue £4 million of perpetual bonds and use the proceeds to repurchase equity. The required return on the bonds is 4%. After the sale of the bonds, Delta will maintain the same capital structure indefinitely. Delta currently generates annual pre-tax earnings of £1 million. This level of earnings is expected to remain constant in perpetuity. The company is subject to 20% corporate tax rate. Assume that there are no transaction costs or financial distress costs.

i) How many shares will the company repurchase as a result of the debt issue?

ii) What is the required return on Delta plc's equity after the restructuring?

iii) Kappa plc is an identical company to Delta plc in every way except their capital structure. It has an equity value of £40 million and debt with the market value of £20 million. The pre-tax cost of debt for Preston is also 4% and the company tax rate is 20%. What is the cost of equity of Kappa?

iv) Now assume that there is cost of financial distress that depends on the level of debt (B). Specifically, the expected cost of financial distress (CFD) for Delta plc is given by CFD=(1/1,000,000)*B^2. What is the level of debt and equity that maximises the value of Delta?

v) Who bears the costs of financial distress, on average? Discuss how firms can reduce the cost of financial distress.