MM Proposition 1: No taxes

Hi guys, i have a question over the application of MM…

Assuming perfect capital markets; Company A is an all-equity company, with share price at $10. It announces to issue debt of $100m to repurchase shares.

By MM, the share price of Company A after announcement of this debt issuance should remain at $10. And the reason behind this is Value(levered firm) = Value(unlevered firm).

While i agree that the firm value stays the same, wouldn’t the market of value equity change as a result of the debt issuance (i.e Equity value goes down because debt went up, overall value stays same). So, wouldn’t share price change accordingly?

Yes, the market value of equity will decrease, by exactly the amount of equity that the company repurchases.

Am i right to say there is no change in share price after the announcement but before the actual repurchase?

Share price should decrease by Δ Debt / # common shares outstanding.

This is due to the increased cost of equity, given the formula rEK = r0 + (r0 -rD) * D/E.

The increase of the cost of equity and corresponding decrease in market value of equity (or share price) outweighs exactly the amount of additional debt.

Regards, Oscar