Recapitalization Corp. is 100% equity financed with 20 million shares of common stock, selling for $50/share. The cost of equity for the all equity firm is 10%. Assume additionally that the annual operating cash flow (assume this is the company’s net earnings, remember there are no taxes) is $100M per year, in perpetuity. Assume the MM (Modigliani Miller) model holds and markets are perfect. Recapitalization Corp. decides it wants to lever the firm up, borrowing $200M at a cost of debt of 5%, paying the proceeds of the loan out to the shareholders. Assume that the debt issue is perpetuity debt. Assume that the assets of the firm are unchanged.
a. What is the new value of the firm, VL ?
b. What is the new value of the equity of the levered firm?
c. Are the shareholders better off after the recapitalization or worse off? Why?
d. What is the new cost of capital of the firm (after the recapitalization)?
e. What is the new cost of equity of the firm (after the recapitalization)?
f. Suppose that the $200M payment to stockholders is accomplished via a repurchase of shares of common stock. The company announces that they will repurchase $200 million worth of shares of common stock. Calculate the new stock price of the company’s stock, Pnew, and how many shares are repurchased at this price, Nrepurchased.