Dream Enterprises is a fully equity financed company and has 6 million shares outstanding with a market price of $10 a share. It announces that it intends to issue $30 million of debt and use the proceeds to buy back its existing shares exist. Assume that the MM assumptions hold (i.e., no taxes, no costs of financial distress).

(a) What is the value of the firm before and after the proposed capital structure change?

(b) What is the debt to equity ratio after the capital structure change?

(c) What is the stock price after the capital structure change?

(d) Do shareholders gain or lose from the capital structure change?

Question 2:

An oil company is drilling a series of new wells on the perimeter of a producing oil field. About 40% of the new wells will be dry. Even if a new well strikes oil, there is still uncertainty about the amount of oil produced: 30% of new wells which strike oil produce only 3,000 barrels a week; 70% produce 40,000 barrels a week.

(a) Forecast the annual revenues from a new perimeter well. Use a future oil price of $100 per barrel.

(b) A geologist proposes to discount the cash flows of the new wells at 10% to offset the risk of drilling but not finding oil. The oil company's normal cost of capital is 5%. Does this proposal make sense? Explain briefly why or why not

Answer rating: 100% (QA)

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