Rayburn Manufacturing is currently an all-equity firm.  The firm's
equity is worth $2 million.  The cost of that equity is 18 percent. 
Rayburn pays no taxes.  Rayburn plans to issue $400,000 in debt and to
use the proceeds to repurchase stock.  The cost of debt is 10 percent
a.  After Rayburn repurchases the stock, what will the firm's overall
cost of capital be?
b.  After the repurchase, what will the cost of equity be?
c.  Explain your result in (b).

Hi lola5!!


a.  After Rayburn repurchases the stock, what will the firm's overall
cost of capital be?

Rayburn is an all-equity firm, then the value of the firm?s assets
equals the value of its equity. MM-Proposition 1 establish that the
value of a firm will not change due to a capital structure change, and
the overall cost of capital will remain unchanged. Therefore, the
Rayburn?s overall cost of capital will be 18%.

                           -------------------

b.  After the repurchase, what will the cost of equity be?

If we call:
rA = expected return on assets
E = equity
D = debt
rD = cost of debt = 10%
V = value of firm = firm's equity worth = $2 million = E + D ==>
==> E = V - D = $2,000,000 - $400,000 = $1,600,000

MM-Proposition 2 states that the cost of equity rE is:

rE = rA + (rA-rD)*D/E =
   = 0.18 + (0.18-0.10)*(400,000/1,600,000) = 
   = 0.20
The cost of equity will be 20%.

                           -------------------

c.  Explain your result in (b).

According with MM-Proposition 2, the expected return on a firm?s
equity will rise with the amount of leverage. This rise occurs because
of the risk added by the debt.

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I hope that this helps you. Please do not hesitate to request for a
clarification if you need it. I will be glad to give you further
assistance on this topic if you need it or if you find something
unclear in this answer.

Best regards.
livioflores-ga

---

Clarification of Answer by livioflores-ga on 10 Apr 2005 21:34 PDT

You can see for reference:
"WWWFinance-Capital Structure and Payout Policies: Campbell R. Harvey":
http://www.duke.edu/~charvey/Classes/ba350/capstruc/capstruc.htm


Hope this helps you to understand the problem.

regards.
livioflores-ga