The firm’s characteristics:

• The firm is zero growth firm

• All earnings are paid out as dividends

• Value of debt (book to value) = 1 000 000

• Market value of equity = 5 257 143

• Sales = 12 000 000

• Variable operating cost = 6 000 000

• Fixed operating cost = 5 000 000

• Income tax rate = 40%

• Cost of debt = 8%

• Cost of equity = 10,5%

• The share price is 20

First proposal

Additional 1 000 000 debt will be used In share repurchase program. The interest rate on new debt will be 9% pa and cost of equity will be 11,5%. The value and yield on “old” debt will not change.

Second proposal

Additional 2 000 000 debt will be used In share repurchase program. The interest rate on new debt will be 12% pa and cost of equity will be 15,0%. The value and yield on “old” debt will not change.

1. Which proposal maximizes firm’s value?

2. Which proposal maximizes stock price (assume information symmetry)

3. What is EPS under each scenario?

4. What will happen if the old debt is not senior to the new debt?