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Question 4 [15 Points]: XYZ Inc. does not have a target debt-to-value ratio, but it has $1 million of risk- free debt in its capital structure (which was supposed to remain at this level forever). Debt is trading at par and has a coupon rate of 3%. Market value of equity is $4 million and there are 100,000 shares outstanding. You can assume that XYZ has only debt and equity in its capital structure and therefore its total market value is $5 million. Debt is 20% of total market value of the firm. Beta (I) for XYZ's equity is currently 1.2. A new management team has replaced the old management, and the new team at XYZ is planning to adopt a new policy regarding its debt and it wants to have a target debt-to-value ratio of 25%. In order to achieve the new target level of debt, the management of XYZ is planning to issue some new debt and it has announced that the new debt will be used to buy back some shares and it will not be used for any new investment. Analysts have said that debt will still be risk-free. The corporate tax rate for XYZ is 30%. There are no personal taxes. If XYZ issues additional debt in order to achieve the target level of debt, then (a) How much new debt should be issued? (b) What will be the new firm value according to Modigliani-Miller's theory in the presence of corporate taxes? (C) What is your estimate of the equity Beta (100) after the issuance of the new debt? (d) What will be the new share price? (A word of caution: When additional debt is issued, the firm value will change from its current $5 million because of additional tax shield created by the new debt.)

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