An un-levered firm, Axe Company Ltd. has an EBIT of $500,000 that it expects it will earn forever. The firm pays all of its earnings as dividends to shareholders (i.e. no growth). The Axe Company Ltd. has 100,000 shares outstanding. When the firm was an un-levered firm, investors required a 12 percent rate of return.
Now assume that the Axe Company Ltd. issues $400,000 of debt with 7.5% coupon that maximized its value. The firm uses this debt to buy back shares. Assume that the firm has a tax rate of 40% and equity investor will require a return of 12.64% at the new level of debt determined using CAPM.
a. What is the market price of a share before any changes in the capital structure?
b. Assuming that the firm uses the proceeds of the new debt to buy back shares, what should be the fair offer price to buy back the shares?
c. How many shares firm can buy back (assume that firm can buy fractional shares)?
d. What is the market price of a share after the restructuring of the capital structure. Show your work to confirm that the new price is the approximately same as in the part c.