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1 April, 14:30

7. Debt Irrelevance. Digital Fruit is financed solely by common stock and has outstanding 25 million shares with a market price of $10 a share. It now announces that it intends to issue $160 million of debt and to use the proceeds to buy back common stock. There are no taxes. (LO16-1) a. What is the expected market price of the common stock after the announcement? b. How many shares can the company buy back with the $160 million of new debt that it will issue? c. What is the market value of the firm (equity plus debt) after the change in capital structure? d. What is the debt ratio after the change in capital structure?

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  1. 1 April, 14:44
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    a. $10 per share

    b. 16 million shares

    c. $250 million

    d. 64%

    Explanation:

    The computations are shown below:

    a. The expected market price of the common stock is same as given in the question i. e $10 per share

    b. The buy back shares would be

    = New debt value : market price per share

    = $160 million : $10

    = 16 million shares

    c. The market value of the firm would be

    = (Outstanding shares - buy back shares) * market price per share + debt value

    = (25 million shares - 16 million shares) * $10 + $160 million

    = $90 million + $1260 million

    = $250 million

    d. The debt ratio would be

    = Debt value : market value of the firm

    = $160 million : 250 million

    = 64%
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