Reference no: EM132959294

You work for Microsoft. Your boss, Steve Ballmer, asks you to evaluate the firm's capital structure. Microsoft currently has a market value of $200 billion and no long-term debt outstanding. You forecast that the firm will earn $10 billion next year and will generate cashflows of $8 billion after all investments have been made. The forecasts are accurate to within +/- $1.2 billion. The firm's marginal tax rate is 40%.

Problem 1: Microsoft is thinking about issuing $30 billion in public bonds. It will use the proceeds from the sale to repurchase equity. How will this transaction affect the riskiness of the firm's equity? Why?

Problem 2: If Microsoft is similar to other firms that have a leverage recapitalization, how will the stock market react to this transaction? Why does the market react this way?

Problem 3: The interest rate on the new debt is 7% and Microsoft plans to roll-over this debt in perpetuity (sell new debt when the old debt matures). How much does the debt add to Microsoft's value? Be precise.

Problem 4: Microsoft currently has a 14% cost of capital. After the leverage recapitalization, will Microsoft's cost of capital be higher, lower, or the same? Why?