The treasurer of G company has proposed that the company should sell equity and buy back debt in order to maximize its value. As evidence she presents the financial statements given in the table below. The company currently has a price / earning ratio of 50. Before the change in capital structure it has 10 shares outstanding; therefore its earning per share are $ 1.00, and the price share is $50. If 10 new shares are issued at $50 each,$500 is collected and used to retire $500 of debt (which pays a coupon rate of 8%). After the capital structure change earning per share have increased to $1.50(since there are now 20 share outstanding);with a price / earning ratio of 50, presumably the price per share will increase from $50 before the capital structure change t0 $75 afterward . Given your understanding of modern financial theory, discuss the above proposal.

income statement

Before After

Net OPerating Income 100 100

Interest expense 80 40

Earnings before taxes 20 60

Taxes at 50% 10 30

Net Income 10 30

Balance sheet

Before After

Assets Liabilities Assets Liabilities

Debt 1000 Debt 500

Equity 500 Equity 1000

Total 1500 Total 1500 Total 1500 Total 1500