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Homework answers / question archive / Assume perfect capital markets
Assume perfect capital markets. A firm is currently financed 80% by equity and 20% by debt. Free cash flows are £9 million per year and are expected to remain constant forever. The firm's levered equity beta is 1. The firm has 40 million shares outstanding. The firm's debt is risk-free and yields 5%. The market risk premium is 5%. There are no taxes. a) What is the total firm value? What is the price of each share? b) Suppose that the firm decides to raise an additional £5 million in debt and to use the proceeds to pay a cash dividend to stockholders. This debt is risk- free. What is the expected return on equity after the firm completes these transactions? What is the new share price? Are shareholders better or worse off as a result of the change in capital structure? Explain your answer. c) Let us abandon the assumption that there are not taxes. Suppose there are corporate taxes. Explain in words (no calculations required) how a £5 million debt issue paid out as a dividend to stockholders would affect shareholder wealth. In other words, are shareholders better or worse off as a result of the change in capital structure when there are corporate taxes? You can assume that the debt remains risk free.
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