Suppose the firm in exercise 14.2 unexpectedly announces that it will issue additional debt, with the same seniority as existing debt and a face value of £50. The firm will use the entire proceeds to repurchase some of the outstanding shares. a What is the market price of the new debt? b Just after the announcement, what will the price of a share jump to?
Suppose the firm in exercise 14.2 unexpectedly announces that it will issue additional debt, with the same seniority as existing debt and a face value of £50. The firm will use the entire proceeds to repurchase some of the outstanding shares. a What is the market price of the new debt? b Just after the announcement, what will the price of a share jump to?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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How do we calculate 14.3 B in this question.
Transcribed Image Text:14.2 Consider a single-period binomial setting where the riskless interest rate is zero, and there
are no taxes. A firm consists of a machine that will produce cash flows of £210 if the economy
is good and £80 if the economy is bad. The good and bad states occur with equal risk-neutral
probability. Initially, the firm has 100 shares outstanding, and debt with a face value of £50
due at the end of the period. What is the share price of the firm?
14.3 Suppose the firm in exercise 14.2 unexpectedly announces that it will issue additional debt,
with the same seniority as existing debt and a face value of £50. The firm will use the entire
proceeds to repurchase some of the outstanding shares.
a What is the market price of the new debt?
b Just after the announcement, what will the price of a share jump to?
c Show how a shareholder with 20 per cent of the shares outstanding is better off as a
result of this transaction when he or she undoes the leverage change.
d Show how the Modigliani-Miller Theorem still holds.
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