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XYZ is considering a capital restructuring to allow $300 million in debt. Currently, XYZ is an all-equity firm with earnings before interest and taxes of $260 million. Assume unlevered firms in the same industry have betas of 0.80. Assume the market risk premium is 6% and the risk-free interest rate is 5%. Assume that the corporate tax rate is 38%. You may assume that all earnings are paid out as dividends, and that the debt is used to buy back stock. For simplicity, assume that cash flows are perpetual as are payments on the debt.
a. How would the proposed restructuring change the value of XYZ as a whole? (Hint: You may not need to compute the new cost of capital to find the new firm value.)
b. If XYZ was considering issuing $2 billion in debt instead of $300 million, would the methodology you used in the previous question be equally appropriate? Why or why not?
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