Exercise 2 (3 points) The XYZ Co. is assessing its current capital structure and its implications for the welfare of its security holders. XYZ is currently financed entirely with equity, of which 1,000 shares are outstanding. Given the risk of the underlying cash flows generated by XYZ, investors currently require a 20% return on equity. The company pays out all free cash flows as dividends to shareholders. XYZ estimates that earnings may be either 1000, 2000, or 4200 with respective probabilities of 0.1, 0.4, and 0.5 depending on future economic conditions. Further, the firm expects to produce a constant stream of cash flows in perpetuity. There are no capital expenditures or changes in net working capital. Assume that corporate taxes are zero and that the firm operates in a perfect capital market. a. Compute firm value and the firm's stock price. b. The CEO of XYZ has come to the conclusion that shareholders would be better off if the company had some debt. He therefore proposes to issue $7,500 of debt at an interest rate of 10% and to use the proceeds to repurchase equity. He commits to keeping the same absolute level of debt in the future. Analyze this proposition: Calculate the share price following the announcement . How many shares does the company repurchase? What is the required rate of return on equity? What is the equity value? Now, lift the assumption of no corporate taxes and instead assume that the corporate tax rate is 40%. c. Compute firm value and the firm's stock price in case of all-equity financing. d. Assume the firm goes through with the recapitalization: . Calculate the share price following the announcement Debt / share price. How many shares does the company repurchase? Who captures the value from the recapitalization? shareholders