Capital Structure

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Firm ABC is financed with equity (market value $400 million) and perpetual debt (market value
$1,000 million). The firm has decided that the current level of leverage is not optimal and wants
to reach a debt-equity ratio of 0.6. In order to achieve this goal, Firm ABC plans to issue equity
and repay some of the existing debt. Assume that the firm operates in a Modigliani and Miller
world (i.e., markets are efficient, no transaction costs, no financial distress costs, etc.) but has a
tax rate of 30%. 

1. Determine the amount of debt the Firm ABC needs to repay to reach the target debt-equity
ratio, and the value of debt and equity after the restructuring. (2 marks) 

2. Assume that there are 20 million shares outstanding before the restructuring. Determine
how many shares Firm ABC must issue to repay the debt needed to reach the target debt-equity
ratio. (3 marks) 

3. Solve part (1) assuming that Firm ABC’s debt is not perpetual but consists of 10-years bonds
with a 10% annual coupon rate and a nominal value of $1,000 million. Debt market value is
still $1,000 million. (3 marks) 

4. Assume now that Firm ABC operates in a tax-free regime. Market value of debt and equity is
still $1,000 million and $400 million, respectively. Determine the amount of debt the Firm
ABC needs to repay to reach the target debt-equity ratio of 0.6, and the value of debt and
equity after the restructuring. Consider both the case in which debt is perpetual and the case
in which debt consists of 10-year bonds (see part 3). (2 marks)

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