Question

7

Executive Chalk is financed solely by common stock and has outstanding 45 million shares with a market price of $50 a share. It now announces that it intends to issue $750 million of debt and to use the proceeds to buy back common stock.

a. How is the market price of the stock affected by the announcement?

	Stock price remains the same.
	Stock price increases.
	Stock price decreases.

b. How many shares can the company buy back with the $750 million of new debt that it issues?(Enter your answer in millions.)

Shares repurchased             million

c-1. What is the market value of the firm (equity plus debt) after the change in capital structure? (Enter your answer in millions.)

Market value            $  million

c-2. Did the market value of the firm change?

	No
	Yes

d. What is the debt ratio after the change in structure? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Debt ratio            

e. Who (if anyone) gains or loses?

	No one gains or loses.
	Shareholders gain and debtholders lose.
	Debtholders gain and shareholders lose.
	Shareholders gain and no one loses.

Answer 1

(a) The question does not mention anything about the tax rates payable by the firm, hence the same is assumed to be zero. In such a scenario, issuance of additional debt will not have the benefit of interest expense tax shield, thereby making this debt issuance irrelevant to the firm in terms of value (stock price) increase/decrease. Therefore, the market price of the stock will remain constant.

(b) Debt Issuance = $ 750 million, Price per Share = $ 50

Shares Repurchased = 750 / 50 = 15 million

(c1) Market Value of Firm post Repurchase = 50 x (45-15) + 750 = $ 2250 million

(c2) As already mentioned in the absence of taxes, the additional debt issuance bears no benefits in the form of interest tax shields, thereby leaving the firm's overall market value unaltered.

NOTE: Please raise separate queries for solutions to the remaining sub-parts, as one query is restricted to the solution of only one question with up to four sub-parts.