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Effect of Debt Issuance on Stock Valuation
Purpose of Assignment
The purpose of this assignment is to demonstrate to students how the issuance of debt to purchase outstanding common stock could affect the value of the company's equity and redefine the capital structure. The problem will also allow students to explore the effect of corporate taxes through debt financing.
Resources: Corporate Finance
Scenario: Hightower, Inc. plans to announce it will issue $2.0 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 5%. Hightower, Inc. is currently an all-equity company worth $7.5 million with 400,000 shares of common stock outstanding. After the sale of the bonds, the company will maintain the new capital structure indefinitely. The company currently generates annual pretax earnings of $1.5 million. This level of earnings is expected to remain constant in perpetuity. The tax rate is 35%.
Prepare a 1,050-word memo advising the management of Hightower, Inc. on the financial impact, including the following:
- What is the expected return on the company's equity before the announcement of the debt issue?
- Construct the company's market value balance sheet before the announcement of the debt issue. What is the price per share of the firm's equity?
- Construct the company's market value balance sheet immediately after the announcement of the debt issue.
- What is the company's stock price per share immediately after the repurchase announcement?
- How many shares will the company repurchase as a result of the debt issue? How many shares of common stock will remain after the repurchase?
- What is the required return on the company's equity after the restructuring?
- Discuss the advantages and disadvantages of debt financing over equity financing.
Show all calculations and submit with your memo.
Format your paper consistent with APA guidelines. Must cite sources