Problem
Suppose that Firm A and Firm B are similar firms, except for different capital structures. Both ?rms generate perpetual EBIT $10,000 per year.
Firrn A has no debt, and the return on firm A's equity is 10%.
Firm B, currently has debt outstanding with a market value $40,000. The interest rate is 6%, which is also the risk-free rate. Both firm A and firm B have 5,000 common shares outstanding. Assume that the tax rate is 40%
Firm B's CFO wants to employ a more aggressive financial leverage policy. Now suppose that firm B's CFO just announced that, the firm will issue $20,000 more debt, and uses the $20,000 to repurchase shares.
Problem: How many shares will firm B repurchase?