Reference no: EM132669069

Consider a company that is financed entirely by equity with a market value of $10 million. Its annual net operating income (NOI) is expected to remain constant over the foreseeable future at $1.5 million per annum. The company operates in a world with perfect capital markets (including no taxation).

The company is considering buying back some of its own shares from its shareholders. The buyback is to be funded entirely by the proceeds of a corporate bond issue. After the bond issue and share buyback the company expects to have a debt (D) to equity (E) ratio of 30%, i.e., D/E = 0.3.

Required:

Problem (a) Calculate the rate of return on equity given the present capital structure (all equity).

Problem (b) Calculate the rate of return on equity following the proposed capital-structure change assuming that (at the new D/E ratio of 30 percent) the company faces a cost of debt of 6%. (Hint: M&M proposition II gives )

Problem (c) Suppose the company increases its ratio of debt to equity further. How do you expect its return on assets, its cost of debt, its cost of equity, and its weighted average cost of capital to change?