Reference no: EM132418033

Part A: XYZ manufacturing is currently an all-equity firm with 10 million shares outstanding and a stock price of £7.00 per share. Although investors currently expect XYZ to remain an all equity firm, the firm plans to announce that it will borrow £40 million and use the funds to repurchase shares. XYZ will pay interest only on this debt, and it has no further plans to increase or decrease the amount of debt. The company is subject to a 40% corporate tax rate.

a) What is the market value of XYZ's existing assets before the announcement?

b) What is the market value of XYZ's assets (including any tax shields) just after the debt is issued, but before the shares are repurchased?

c) What is XYZ's share price just before the share repurchase? How many shares will the firm repurchase?

d) What are XYZ's market value of assets, debt and equity and share price after the share repurchase?

e) Briefly explain how the shareholders benefit from a leveraged recap when it reduces the total value of equity.

Part B: Suppose a firm's tax rate is 35%.

i. What effect would a £10 million operating expense have on this year's earnings? What effect would it have on next year's earnings?

ii. What effect would a £10 million capital expense have on this year's earnings if the capital is depreciated at a rate of £2 million per year for five years? What effect would it have on next year's earnings?