CAPITAL STRUCTURE, PAYOUT POLICY AND COST OF CAPITAL
Pharma-C is a pharmaceutical firm that manufactures and sells aportfolio of blockbuster drugs at high margins. The firm isall-equity financed and has 40 million shares outstanding at aprice of $75 per share. Pharma-C’s current cost of capital is 7.5%.The firm is considering to buy back $400 million in shares in theopen market and to finance the repurchase by issuing bonds.Pharma-C plans to maintain this capital structure indefinitely. Atthis level of debt, the bonds would be A-rated, and the firm wouldpay an interest rate of 4.5%. Pharma C’s- marginal corporate taxrate is 25%. With this information answer the followingthree questions.
- Calculate the stock price of Pharma-C when the share repurchaseplan is announced to the market, and also determine how many sharesthe firm would need to repurchase. Clearly describe yourapproach.
- Determine Pharma-C’s cost of equity and its cost of capitalafter the share repurchase and explain the directional change forboth.
- Now suppose that the stock price upon announcement of the sharerepurchase plan equals $77.90. If we assume that the market isefficient, and the firm has not released any other information,what can you infer from this regarding the market’s assessment ofPharma-C’s cost of financial distress, and how would you estimatethese costs? Motivate your approach and discuss the inputs in anycalculations.
