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CAPITAL STRUCTURE, PAYOUT POLICY AND COST OF CAPITAL

Pharma-C is a pharmaceutical firm that manufactures and sells a portfolio of blockbuster drugs at high margins. The firm is all-equity financed and has 40 million shares outstanding at a price of $75 per share. Pharma-Cs current cost of capital is 7.5%. The firm is considering to buy back $400 million in shares in the open market and to finance the repurchase by issuing bonds. Pharma-C plans to maintain this capital structure indefinitely. At this level of debt, the bonds would be A-rated, and the firm would pay an interest rate of 4.5%. Pharma Cs- marginal corporate tax rate is 25%. With this information answer the following three questions.

1. Calculate the stock price of Pharma-C when the share repurchase plan is announced to the market, and also determine how many shares the firm would need to repurchase. Clearly describe your approach.
2. Determine Pharma-Cs cost of equity and its cost of capital after the share repurchase and explain the directional change for both.
3. Now suppose that the stock price upon announcement of the share repurchase plan equals $77.90. If we assume that the market is efficient, and the firm has not released any other information, what can you infer from this regarding the markets assessment of Pharma-Cs cost of financial distress, and how would you estimate these costs? Motivate your approach and discuss the inputs in any calculations.

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