As the chief financial officer of Magnitude Limited, you are considering a recapitalisation plan that would convert Magnitude Limited from its all current all-equity capital structure to one that includes substantial financial leverage. Magnitude now has 500 000 ordinary shares outstanding, which are selling for N$60 each. You expect the firm’s annual cash flow, before interest and taxes to be N$2 400 000 for the foreseeable future.
The recapitalisation proposal is to issue N$15 000 000 worth of long term debt, at an interest rate of 6%, and then to use the proceeds to repurchase 250 000 ordinary shares worth N$15 000 000. Assuming there are no market frictions such as corporate or personal income taxes, calculate the expected return on equity for Magnitude shareholders under the current all-equity capital structure and also under the proposed recapitalisation.