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An all equity business has 100 million shares outstanding selling for $20 per share. Management believes that interest rates are unreasonably low and decides to execute a dividend recapitalization (a recap). It will raise $1 billion in debt and repurchase 50 million shares.
(a) What is the market value of the firm prior to the recap? What is the market value of equity?
(b) Assuming the Irrelevance Proposition holds, what is the market value of the firm after the recap? What is the market value of the equity?
(c) Do equity shareholders appear to have gained or lost as a result of the recap? Please explain.
(d) Assume now that the recap increases total firm cash flows, which adds $100 million to the value of the firm. Now what is the market value of the firm? What is the market value of equity?
(e) Do equity shareholders appear to have gained or lost as a result of the recap in this revised scenario?
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