Read each question carefully and show all of your work clearly on the short-answer problems as partial credit will be given.

#1. Buckeye Corp. is currently an all-equity firm with a market value of equity of $100 million. The current expected return on Buckeye’s equity is 25%. Buckeye operates in a world with no taxes. Buckeye is planning on issuing $10 million in debt with an interest rate of 10% and using the cash to repurchase $10 million in shares. There are no corporate or personal taxes. (6 points)

(a) After Buckeye repurchases the stock, what will be the expected return on the firm’s stock?

(b) After Buckeye repurchases the stock, what will be the firm’s weighted average cost of capital?

#2. Green Manufacturing is an all equity firm with a current market value of $20,000,000 and 500,000 shares outstanding. The current expected return on the firm’s stock is 20%. Green plans to announce that it will issue $2,000,000 of perpetual bonds and use these funds to repurchase equity. The bonds will have a 6% interest rate. After the sale of the bonds and the share repurchase, Green will maintain the new capital structure indefinitely. The corporate tax rate for

Green is 30% and there are no personal taxes. (12 points)

(a) What will the stock price be immediately after Green announces its plan to issue bonds and

repurchase equity?

(b) What will the total market value of the firm’s equity be immediately after Green announces

its plan to issue bonds and repurchase equity?

(c) How many shares will Green repurchase?

(d) What will be the market value of Green’s equity after the bond issue and share repurchase are

completed?

(e) What was Green’s weighted average cost of capital before the change in capital structure?

(f) What is Green’s weighted average cost of capital after the change in capital structure?

Chapter 17

Read the question carefully and show all of your work clearly on the short-answer problems as partial credit will be given.

#1. Fountain Corporation economists estimate that the probability of a good business environment next year is equal to the probability of a bad environment. Knowing this, the managers of Fountain must choose between two mutually exclusive projects. Suppose the payoff from the chosen project is the only future cash flow expected by the firm. Fountain is obliged to make a $1000 payment to its bondholders next year. Here is a description of the projects:

Low Risk Project

Probability   Payoff    Value of Stock    Value of Bonds

Recession              .5             1000               0                        1000

Boom                     .5            1400            400                       1000

High Risk Project

Probability   Payoff    Value of Stock   Value of Bonds

Recession               .5              200               0                          200

Boom                      .5            1600            600                       1000

Which project will the stockholders prefer? Which project maximizes the value of the firm? Why are these answers different? (5 points)

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