Johnson & James Plc, an unlevered company operates in perfect markets and has a net operating income (EBIT) of £2 million. Assume that the required return on assets for firms in this industry is 8%. Johnson & James Plc issues £10 million worth of debt, with a required return of 6.5 percent, and uses the proceeds to repurchase outstanding shares. There are no corporate or personal taxes.

What is the market value and required return of this firm’s shares before the repurchase transaction, according to M&M Proposition I?

What is the market value and required return of this firm’s remaining shares after the repurchase transaction, according to M&M Proposition II?

Suppose that the risk-free rate of interest is 5% and the expected rate of return on the market is 17%. A share of Johnson & James Plc sells for £60 today. Johnson & James Plc will pay a dividend of £7 per share at the end of the year. Its beta is 1.3. What do investors expect the stock to sell for at the end of the year?

If Johnson & James Plc decides to issue a 10-year corporate bond with a face value of £10,000 that pays a coupon of 5.5%, (2.75% of face value every six months). The semiannually compounded interest rate is 5.2% (a six-month discount rate of 5.2/2 = 2.6%). What is the present value of the bond?

Explain four factors that must be considered by a listed company when choosing between an issue of debt and an issue of equity finance.

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