An unlevered firm has a perpetual cash flow depending on the state of the economy as follows: EconomyCash FlowProbability Strong 1500 55% Weak 900…

An unlevered firm has a perpetual cash flow depending on the state of the economy as follows:

EconomyCash FlowProbability

Strong 1500 55%

Weak 900 45%

The firm has

Ru =15%

N0 =1000.00shares outstanding.

The company plans to recapitalize its capital structure by issuing a perpetual debt (a debt that pays a perpetual interest) to buy back shares to achieve D/E ratio of

D/E =1.50

Suppose the riskless rate is

Rf =10%

Can the firm issue risk-free debt?

At what price will the firm have to pay for its shares and how many shares will be repurchased? Draw the market value balance sheet for the transaction

What is the cost of equity capital after the transaction?

What is the firm’s expected equity cash flow per share after the recap? How does it change from before the recap?

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