You are the new CFO of Megasoft. Megasoft has $ 1billion market value. It currently has no debt. Corporate tax rate is 40%. You make a compelling argument to the board that debt will enhance shareholder value.The board authorizes you to issue risk-free debt and buyback some stock using ALL the proceeds of debt. The board wants the post-leverage capital structure to have exactly 20% debt (B/VL=0.2). You will soon make an announcement to the shareholders about your plans to issue debt and buyback some stock.
1) How much debt will you need? (Be careful. As soon as the announcement is made, the stock will go up to reflect the benefits of debt. VL=VU+TB. You need enough B to buy back 20% of VL)
2) Suppose you owned $ 1,000 worth of shares before the announcement. What will be the value of your shares after Megasoft is levered. Assume that you don’t sell any shares.