Capital Structure Forest Led is planning to repurchase part of its common stock by issuing debt. As a result the firm's debt-equity ratio is expected to rise from 40 percent to 50 percent. The firm currently has \\( \\$ 7,500,000 \\) debt outstanding. The cost of this debt is 10 percent per year. Forest Ltd expects to have an EBIT of \\( \\$ 5,750,000 \\) per year in perpetuity. The corporate tax rate is 40 percent. Required: According to Modigliani and Miller's theory of the valuation of the firm with corporate taxes: (a) What is the market value of Forest Lid before the repurchase announcement? (b) What is the market value of Forest Ltd after the repurchase announcement? [Hint This is the toughest part of the problem. Don't feel bad if you get lost in here. Just do your best. Also, you do not need to work this part out to do the rest of the problem] (c) What is the expected return on the firm's equity before the announcement of the stock repurchase plan? [Hint calculate ROE first] (d) What is the expected return on equity of an otherwise identical all-equity firm? (e) What is the expected return on the firm's equity after the announcement of the stock repurchase plan? Question 2 Capital Structure Soho Ltd and Seine Ltd are identical in every way except their capital structures. Soho Lid, an all-equity firm, has 10,000 shares of stock outstanding, currently worth \\( \\$ 18 \\) per share. Seine Ltd uses leverage in its capital structure. The market value of Seine's debt is \\( \\$ 60,000 \\) and its cost of debt is 12 percent. Each firm is expected to have earnings before interest of \\( \\$ 40.000 \\) in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 12 percent per year. Required: (a) If you use market capitalisation as your starting point, rather than discounting EBIT, what are the values of Soho Ltd and Seine Lid? (b) How much will it cost to purchase 20 percent of Each firm's equity?) (c) Assuming that an investor owns 20 percent of the equity of each firm. If each firm meets its earnings estimates, what will be the dollar return to the investor from each firm over the next year? What will be the two ROEs be? (d) Construct an investment strategy in which an investor purchases 20 percent of Soho's equity and replicates both the cost and dollar return of purchasing 20 percent of Seine's equity. Note: The model answer for this problem also provides calculations for when EBIT is set at \\( \\$ 35,000 \\). While you are not expected to work through this for the homework, you might find it useful for gaining confidence in handling this kind of problem-solving