Spam Corp. is financed entirely by common stock and has a beta of 1.0. The firm is

Question:

Spam Corp. is financed entirely by common stock and has a beta of 1.0. The firm is expected to generate a level, perpetual stream of earnings and dividends. The stock has a price–earnings ratio of 8 and a cost of equity of 12.5%. The company’s stock is selling for $50. Now the firm decides to repurchase half of its shares and substitute an equal value of debt. The debt is risk-free, with a 5% interest rate. The company is exempt from corporate income taxes. Assuming MM are correct, calculate the following items after the refinancing:

a. The cost of equity.

b. The overall cost of capital (WACC).

c. The price–earnings ratio.

d. The stock price.

e. The stock’s beta.

Common Stock
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