Assume that Rose Corporation’s (RC) EBIT is not expected to grow in the future a

Question

Assume that Rose Corporation’s (RC) EBIT is not expected to grow in the future and that all earnings are paid out as dividends. RC is currently an all-equity firm. It expects to generate earnings before interest and taxes (EBIT) of $6 million over the next year. Currently, RC has 5 million shares outstanding and its stock is trading for a price of $12 per share. RC is considering borrowing $12 million at a rate of 6% and using the proceeds to repurchase shares at the current price of $12.


Following the borrowing of $12million and subsequent share repurchase, the value of a share of RC is closest to:

(1) $14.00
(2) $13.20
(3) $12.00
(4) $10.80

Explanation / Answer

Ans: $12.00 In a perfect market condition, share price of RC should not change after the repurchase, hence should remain close to $12.

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