Lanley Monorails Inc.is all equity financed and generates perpetual annual EBIT of $300.Assume that the EBIT,and all other cash flows,occur at year end and that we are currently at the beginning of a year.Assume that Lanley has a 100% payout rate,1,500 shares outstanding,and that shareholders require a return of 5%.Assume that the tax rate is 0%.
Lanley Monorails is considering an open market stock repurchase.It plans to buy 20% of its outstanding shares at the price of $4.00 per share.The repurchased shares will be cancelled.It will finance the repurchase by issuing perpetual bonds worth a total sum of $1,200 and a coupon rate (and yield)of 3%.Assume that the tax rate is 0%.
If Lanley goes ahead with the repurchase,then what is the required return of stock holders after the repurchase is complete?

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Quizplus · Accepted Answer

The required return of shareholders in the levered firm is given by M&M Proposition II: k_E = k_U + (k_U - k_D) 11ea7fdb_fc62_0948_a768_5790afb79009_TB2902_11 Since V_L = E + D E = V_L - D According to M&M Proposition I, the value of the levered firm is equal to the unlevered firm. V_L = V_U = 11ea7fdb_fc62_0949_a768_07a2a6883a98_TB2902_11 = $6,000 E = $6,000 - $1,200 = $4,800 k_E = 0.05 + (0.05 - 0.03) 11ea7fdb_fc62_094a_a768_fda02c42d347_TB2902_11 = 0.055 or 5.5%