Capital Structure Forest Ltd is planning to repurchase part of its common stock by issuing...
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Finance
Capital Structure Forest Ltd is planning to repurchase part of its common stock by issuing debt. As a result the firms 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 Millers theory of the valuation of the firm with corporate taxes:
(a) What is the market value of Forest Ltd 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. Dont 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 firms 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 firms equity after the announcement of the stock repurchase plan?
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