ZXC Inc. earns $250,000 EBIT on average per year and forever. It always distributes all its net earnings as dividends to its shareholders. Net working capital is always kept at zero, and there are no capital spendings. ZXC's current capital structure is 90% equity and 10% debt. There are 100,000 common shares outstanding. ZXC's current cost of equity is 16% and its cost of debt is 10%. The corporate tax rate is 40%. The CEO of ZXC Inc. considers issuing additional debt and use the proceeds to buy back shares. To be specific, the CEO is thinking about offering $0.5 million perpetual debt paying 10% coupon rate and using the money to buy back some of the shares. Ignore any bankruptcy considerations.

(a) (10 points) What is the market value of ZXC Inc. if it keeps its current capital structure? What is the share price?

(b) (5 points) What is the market value of ZXC Inc. after it issues $0.5 million perpetual debt paying 10% coupon per year and uses the proceeds for share buyback?

(c) (10 points) What is the cost of equity and WACC of ZXC Inc. after it issues the debt?

(d) (10 points) How many shares will ZXC Inc. be able to buy back? What is the new share price?

Hint: Write down two equations. The first one should show that funds from the debt issuance are used to buy back shares. The second one should show that the remaining value of shares equal to the new equity value.

Answer rating: 100% (QA)

To solve this problem lets start by calculating the market value of ZXC Inc under its current capital structure a Market Value of ZXC Inc with Current ... View the full answer