Locomotive Corporation is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firm’s debt–equity ratio is expected to rise from 30 percent to 45 percent. The firm currently has $10 million worth of debt outstanding. The cost of this debt is 6.5 percent per year. The firm expects to have an EBIT of $3 million per year in perpetuity and pays no taxes.
a. What is the market value of the firm before and after the repurchase announcement?
b. What is the expected return on the firm’s equity before the announcement of the stock repurchase plan?
c. What is the expected return on the equity of an otherwise identical all-equity firm?
d. What is the expected return on the firm’s equity after the announcement of the stock repurchase plan?