Allright, I am absolutely stuck in this question, the instructor never teach this stuff, and yet he expects us to solve it! :| What a moron! Anyway, I won't bother you with more rant, here is the question:
Suppose you own some shares of Microsoft worth $1,000. Beta of Microsoft is 2. Microsoft currently has no debt. Microsoft decides to issue debt and buy back some of its stock in open market. Specifically, Microsoft decides to buy back 20% of its stock using ALL the proceeds of a new issue of risk-free bonds. Corporate tax rate is zero. You decide to not sell any part of your shares.
a) What is the value of your shares after the buyback is completed.
b) What is the beta of your shares after the buyback is completed.
c) After the company is levered, you decide to sell some of your shares and invest the proceeds in risk-free bonds. You want to do this ?rebalancing? so that your portfolio (shares+bonds) will have the same beta as the unlevered shares (beta of 2). Effectively, you want to undo the leverage of Microsoft. What fraction of your money will be invested in risk-free bonds?
The answer to A should be $1000 ( I think), since the finance restructuring has nothing to do with the value of the shares. But what about B part and C part?
Suppose you own some shares of Microsoft worth $1,000. Beta of Microsoft is 2. Microsoft currently has no debt. Microsoft decides to issue debt and buy back some of its stock in open market. Specifically, Microsoft decides to buy back 20% of its stock using ALL the proceeds of a new issue of risk-free bonds. Corporate tax rate is zero. You decide to not sell any part of your shares.
a) What is the value of your shares after the buyback is completed.
b) What is the beta of your shares after the buyback is completed.
c) After the company is levered, you decide to sell some of your shares and invest the proceeds in risk-free bonds. You want to do this ?rebalancing? so that your portfolio (shares+bonds) will have the same beta as the unlevered shares (beta of 2). Effectively, you want to undo the leverage of Microsoft. What fraction of your money will be invested in risk-free bonds?
The answer to A should be $1000 ( I think), since the finance restructuring has nothing to do with the value of the shares. But what about B part and C part?
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