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Proportions of debt and equity

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Reference no: EM132718999

ABC is currently financed entirely with common stock with 1,000 shares outstanding.

Given the risk of the underlying cash flows generated by ABC, investors currently require a 20% return on the ABC common stock.

The company pays out all expected earnings as dividends to common stockholders.

ABC estimates that operating income to be 3,000 and the firm expects to produce a level stream of earnings in perpetuity.

Assume that the corporate tax rates are equal to zero.

(a) Given the above facts, compute:

(i) the value of the firm;
(ii) the market value of a common share;
(iii) the expected earnings per share of common stock;
(iv) the firm's average cost of capital.

The president of ABC has believes that shareholders would be better off if the company had equal proportions of debt and equity. He therefore issues $7,500 of debt at an interest rate of 10% and use the proceeds to repurchase equity.

(b) Analyze this proposition by computing

(i) the new value of the firm;
(ii) the value of debt;
(iii) the value of equity;
(iv) the number of shares repurchased, and the price of one such share;
(v) the required rate of return on equity;
(vi) the firm's weighted average cost of capital.

Reference no: EM132718999

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