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Analyzing a Firm’s Capital Structure

Assume that a company has $10 million in assets (where the market value of the assets is equal to the book value of the assets) and no debt.  The company’s marginal tax rate is 35% and has 500,000 shares outstanding.  The company’s earnings before interest and taxes (EBIT) is $3.88 million.  The firm’s stock price is $27 per share and the cost of equity is 11%.

The company is thinking of issuing bonds and simultaneously repurchasing a portion of its stock.  If the company changes its capital structure from no debt to 25% debt based on market values, the firm’s cost of equity will increase