Reference no: EM132444286

1. Suppose we have two equally risky firms, Firm A and B. Firm B's shares are currently worth $100, and they are expected to be worth $120 in one year. Personal dividend tax rate is 30%, and capital gains are exempt from taxes.

a. What is the after-tax return on Firm B?

b. If Firm A opts to pay a dividend of $20 per share in one year, what is the after-tax return on Firm A?

c. Given that dividends will reduce firm value proportionally, what is the share price of Firm A's stock if it pays a dividend of $20 in one year?

2. STU's Disco Factory Inc. is financed solely by equity and it is considering issuing debt and using the proceeds to repurchase some of the outstanding shares at the current market price of $30. There are currently 200,000 shares outstanding. EBIT is expected to remain at $1.5 million, with all earnings paid out as dividends. The firm can issue debt at a rate of 8%, and the firm's tax rate is 40%. Three alternative amounts of debt are being considered:

Amount of debt: $0 and 15% required return, $1,000,000 and 15.5% required return, $2,000,000 and 16% required return

Assume that all stock repurchases will be made at $30 per share.

a. Using the M&M Proposition I with taxes, calculate the value of the firm at each debt level.

b. What is the optimum amount of debt?

c. Show that, at the optimum capital structure, the firm also minimizes the WACC.

d. Show that, at the optimum capital structure, the firm also maximizes the price of the outstanding shares.