Edison Electric has $1 billion market capitalization, 10 million
shares trading at $100/share. Currently, its equity beta is 1.8. It
also has $0.5 billion (market value) of debt outstanding with a
yield-to-maturity of 7%. The Treasury bill rate is 5% and the
market risk premium is estimated at 8%. Edison’s tax rate is 34%.
Assume everything else in the perfect markets hold throughout your
analysis, and that CAPM determines the risk-return relationship for
all assets: business projects, stock, bonds, etc.
Suppose Edison announces that it is issuing $1 billion of new
debt at 9% in order to retire the entire $0.5 billion of old debt
(they will pay $0.5 billion for it) and to repurchase $0.5 billion
of outstanding stock at market prices.
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