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B) At a market price of $12 per share the company can buy back ($60 million/
$12)= 5 million shares.
E) Shareholders gain $30 million from the price increase in the stock while
existing debt holders actually lose $30 million from the market value of the
existing debt falling from $100 million to $70 million.
2. A) Equity = $80 with 50% chance and $40 with 50% chance
Debt = $0
L = max (0, ((($80+$40)/2)/2)) = $30
3. A) P = 100p+40(1-p)+1 = 60p+41
Shareholders retain: (1-(.5/(60p+41)))(100+1)
Shareholders have to retain > 100 if a VH firm issues equity, otherwise it will
send a negative signal to shareholders and shareholders will think the firm is
actually a VL firm.
→ (1-(.5/(60p+41)))(101)>100
(1-(.5/(60p+41)))>(100/101)
→ 60p>9.5 → p>.1583
B) A VL firm will issue equity if issuing equity will cause shareholders to retain
>40 since it’s real value is only 40.
p=.05 → P=60(.05)+41 =44
Shareholders retain: (1-(.5/44))(41) = 40.534
Since 40.534>40 the VL firm will issue equity
C) At p=.1 the VL firm issues equity but the VH firm does not. The VH firm
needs p>.1583 to issue equity.
p=.1 → P0=60(.1)+40 = 46
By issuing equity when p=.1 investors will know that the firm is a V L firm and
thus p=0 in which case the value of the firm P1=60(0)+40+1=41
Thus the value of the firm goes from 46 to 41, a change of -5
C) Including the 50,000 new shares, the total dividends will be divided up into
1.05 million shares. Since the total dividends at t=2 will be $1.05 million, the
dividends per share will be $1 and will increase by 5% each year.
D) Current shareholders get $2 per share in year one and $1 per share in year
two which then grows at 5%.