Question: The Botolph Corporation produces botolphinators. Next year, Botolph will have EBIT (earnings before interest and taxes) of $200. This EBIT will be constant forever. The appropriate (all-equity) discount rate is 20% for the botolphinator business. Botolph currently has debt of $500, which is in the form of perpetual bonds (consols). Botolph plans (and the market believes) to keep this level of debt permanently. The debt is riskless, and the (constant) riskless interest rate is 5%.
There are no personal taxes, and the corporate tax rate is 20%.
A) What is the current value of the Botolph's equity?
B) Botolph unexpectedly announces that it will be switching to a new, permanent level of $600 worth of debt. The debt is still riskless. Botolph plans to issue the $100 in additional debt, and use the proceeds to repurchase equity. The market believes, again, that this $600 level will never change. What is the percentage change in Botolph's stock price, when the announcement takes place?
C) After they have issued the debt, what is the value of Botolph's market equity?
D) What is the expected rate of return on Botolph's equity, after they have issued the new debt? (Hint: Do not make any assumptions about the market risk premium. Do not try to use the CAPM. Use your answer in part C)
E) Evaluate the following statement, explaining why it is right or wrong. Are the facts correct? Is the reasoning correct? Botolph's stock price rises (in part B) because expected returns on Botolph's stock rise (part D) after the debt is issued. The stock has become more valuable because expected returns have gone up.
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