Reference no: EM133168962

Question - Recapitalization in Perfect Markets - For this problem, ignore taxes, bankruptcy costs and any other market frictions.

Olin Mfg. has assets that will produce total cash flow in one year (and none thereafter) of either $200 million or $260 million, depending on the state of the economy. Suppose that these outcomes are equally likely. The firm is currently all-equity financed. Under their current all-equity financial structure, the expected return on their equity (rE) is 15%. Olin is considering changing capital structures by borrowing $50 million and using the proceeds to repurchase equity. At this level of debt, the interest rate on the debt will be 6%.

After this change in capital structure:

1) What will be the market value of the equity?

2) What will be the expected return to equity holders (rE)?

3) What will be the weighted average cost of capital?

Suppose that Olin subsequently decides to increase the debt issuance to $75 mm, still using all the proceeds to repurchase shares.

4) As a result of this higher debt level, we expect the weighted average cost of capital to be (circle one):

a. Lower than in part 3)

b. Same as in part 3)

c. Higher than in part 3)

5) As a result of this higher debt level, we anticipate the expected return to equity holders (rE) will be (circle one):

a. Lower than in part 2)

b. Same as in part 2)

c. Higher than in part 2)

6) As a result of this higher debt level, we expect the Price/Earnings ratio to be (circle one):

a. Lower than with $50 million in debt

b. Same as with $50 million in debt

c. Higher than with $50 million in debt