Frequently Asked Questions

In exercise 3, the firm is considering the issuance of €25 million of debt and buy back shares. Here, students ask why the share price remains the same before and after the issuance of debt. The reason is that the NPV of the debt issue is zero as all the MM assumptions hold and so capital structure has no impact on the value of the firm.

On the other hand, in exercise 4 the share price goes from €100 to €96.75 after the debt issuance. This happens because there are two imperfections here: taxes and bankruptcy and so the NPV of the debt issue should take into consideration the PV of the Interest tax shield as well as the PV of costs of financial distress.

Students should aim to understand what the NPV of the project is in each situation. The project in this case is the debt issue. On announcement of the debt issue, the stock price immediately reflects the new information that the firm is doing a negative NPV project. On announcement, the firm has not undertaken the project yet and so the number of shares outstanding are unchanged at this point. And so the value of the firm (and of equity) becomes V = Vu + NPV = 100 - 3.25 = 96.75. Dividing this by 1 million shares outstanding, we can obtain the share price. After this, the firm issues debt and repurchases shares, but no new information becomes available and therefore the share price does not change further.

Note: For more details, consult the video lecture on Capital Structure between slides 5 and 11 (NPV and the value of the firm).