Answer: Good choice. You earned $10. Poor choice. You lost $10.

The cost of debt ##(r_D)## is the yield of the bond, 10%. The cost of equity ##(r_E)## is the required return on equity which can be found using the CAPM since we have the beta on levered equity, risk free rate and expected return on the market portfolio. The cost of equity can also be found from the DDM but not in this case since we do not have the dividend or its growth rate. The risk free rate is the yield on government bonds, 6%.

###\begin{aligned} r_E &= r_f + \beta_E(r_m - r_f) \\ &= 0.06 + 2(0.1 - 0.06) \\ &= 0.14 \\ \end{aligned}###

The WACC after tax is then:

###\begin{aligned} r_\text{WACC after tax} &= {r_D.(1-t_c).\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L}} \\ &= {0.1 \times (1-0.3)\times\frac{1m}{1m+1m} + 0.14 \times \frac{1m}{1m+1m}} \\ &= 0.105 \\ \end{aligned}###

Answer: Good choice. You earned $10. Poor choice. You lost $10.

The unlevered service project's cash flows should be discounted by other service firms' WACC after tax.

There are two parts to this question. The first is about how to take the interest tax shield into account. The second is about how to adjust for the higher systematic risk of the project.

Treatment of the interest tax shield

To find the value of the levered project (##V_L##), the unlevered CFFA, also called the operating free cash flow (OFCF), should be discounted by the WACC after tax. This is called the 'text book' method of valuation. If the unlevered CFFA will occur in perpetuity with no growth, then:

###V_L = \frac{CFFA_U}{r_\text{WACC after tax}} = \frac{NI+Depr-CapEx - \varDelta NWC}{r_D.(1-t_c).\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L}}###

The tax shield is taken into account in the discount rate (##r_\text{WACC after tax}##), not the cash flow (##CFFA_U##). The after tax WACC takes the interest tax shield into account by reducing the cost of debt by the corporate tax rate: ###r_\text{WACC after tax} = r_D.\mathbf{(1-t_c)}.\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L}###

The unlevered CFFA (##CFFA_U##) excludes interest expense (##IntExp=0##) and therefore doesn't take the interest tax shield into account:

###CFFA_U=NI+Depr-CapEx - \varDelta NWC###

Treatment of the higher systematic risk of the project

The WACC after (and before) tax is supposed to reflect the systematic risk of the cash flows. Since the project is in the more systematically risky services industry, the high WACC of a services firm should be used, not the low WACC of the manufacturing firm which has less systematic risk.

Additionally, discounting by the WACC after tax only works if the firm always has the same proportion of debt. If the debt-to-assets ratio changes then the amount of tax shields will change and the after-tax WACC must be recalculated every year.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

The first sentence of each answer choice is correct, but the second sentence reaches a conclusion which is not correct (except for answer b).

Debt does make a firm's equity more risky and the higher the amount of debt, the higher the cost of equity. This is because debt 'levers up' or amplifies the returns to equity, causing the returns on equity to become more extreme and therefore more risky. Both the systematic and idiosyncratic risk of the firm's equity will increase when the firm's debt-to-assets ratio (##D/V_L##) rises. Due to the equities' higher systematic risk (higher equity beta), the firm's shares will have a higher expected return.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

The WACC before tax, also known as the opportunity cost of capital or the required return on assets (##r_{VL}##), will increase when the firm's systematic risk increases. This is because the WACC before tax takes the time value of money and the systematic risk into account. This is apparent when you consider the two different ways to calculate the WACC before tax.

There is the familiar formula which is the weighted average cost of the equity and debt used to finance the firm's assets:

###r_\text{WACC before tax} = r_D.\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L}###

Since ##V=D+E##, this should be equal to the required return on the firm's assets using the CAPM with the firm's asset beta:

###r_\text{WACC before tax} = r_{VL} = {r_f} + \beta_{VL}(r_m - r_f)###

This CAPM version of the WACC before tax equation breaks the required return into the time value of money (##r_f##) and the systematic risk premium (##\beta_{VL}(r_m - r_f)##).

The higher the correlation of the firm's returns with the market ##(\rho_{VL,M})##, the higher the levered asset beta ##(\beta_{VL})##, the higher the WACC before tax.

###\beta_{VL} = \rho_{VL,M}.\dfrac{\sigma_{VL}}{\sigma_M} ###

Answer: Good choice. You earned $10. Poor choice. You lost $10.

The firm's before-tax WACC will stay the same. The reason is because it only takes the time value of money and systematic risk of the business into account. It does not include the benefit of the tax shields, unlike the WACC after tax which will decrease.

By funding the project with bonds, the firm's gearing ratios will increase, so the first two answers are correct. The value of interest tax shields will also increase with more debt, so answer (c) is also correct.

Note that it's a common mistake to think that because the proportion of debt increases, the WACC before and after tax will decrease because there is a higher weight in debt which which has a low required return, and a lower weight in equity which has a higher required return. The logic of this statement is very nearly correct.

It is true that the weights in debt and equity rise and fall respectively.

It is true that ##r_D < r_E## because from an investor's point of view, debt is paid out before equity in the event of bankruptcy and therefore has less systematic risk (##\beta_D < \beta_E##) and therefore deserves a lower return.

But the last important effect of the higher leverage is that the returns to equity will be amplified. They will be more sensitive to the return on assets and therefore have more systematic risk. This increase in the required return on equity (##r_E##) will cancel out the higher weight in the cheaper cost of debt (##r_D##), leaving the WACC before tax unchanged.

Note that we assume that the cost of debt will remain unchanged which is strictly wrong, it should increase slightly since the more debt, the higher the risk of default (which has a systematic risk component) and the higher the yield on the debt.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

In this case the after tax WACC is the correct answer. Let's look at the pre tax WACC first to examine why.

The pre tax WACC is very useful since it accounts for the time value of money and systematic risk. To find the levered value of a firm's project, levered cash flows are discounted by the pre tax WACC, so the value of the interest tax shield is included in the cash flow. In this question, we are given the unlevered cash flows, the cash flows with no interest expense and therefore no debt. If these unlevered cash flows are discounted by the pre tax WACC, the value of the firm's project will be undervalued since it will exclude the value of interest tax shields.

The after tax WACC is exactly the same as the pre tax WACC, except it also reduces the cost of debt by the amount of the interest tax shield. It uses the after-tax cost of debt (##r_D(1-t_c)##) rather than the pre-tax cost of debt (##r_D##). To find the levered value of the firm's project, unlevered cash flows are discounted by the after tax WACC. In this case the value of the interest tax shield will be included in the discount rate, the after tax WACC. This will value the levered firm's project including the value of the interest tax shields, giving an accurate valuation.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

The unlevered manufacturing business's cash flows should be discounted by other manufacturing firms' WACC after tax.

There are two parts to this question. The first is about how to take the interest tax shield into account. The second is about how to adjust for the higher systematic risk of the manufacturing project compared to the existing retail business.

Treatment of the interest tax shield

To find the value of the levered project (##V_L##), the unlevered CFFA should be discounted by the WACC after tax. This is called the 'text book' method of valuation. If the unlevered CFFA will occur in perpetuity with no growth, then:

###V_L = \frac{CFFA_U}{r_\text{WACC after tax}} = \frac{NI+Depr-CapEx - \varDelta NWC}{r_D.(1-t_c).\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L}}###

The tax shield is taken into account in the discount rate (##r_\text{WACC after tax}##), not the cash flow (##CFFA_U##). The after tax WACC takes the interest tax shield into account by reducing the cost of debt by the corporate tax rate: ###r_\text{WACC after tax} = r_D.\mathbf{(1-t_c)}.\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L}###

The unlevered cash flow (##CFFA_U##) excludes interest expense (##IntExp=0##) and therefore doesn't take the interest tax shield into account:

###CFFA_U=NI+Depr-CapEx - \varDelta NWC###

Treatment of the higher systematic risk of the project

The WACC after (and before) tax is supposed to reflect the systematic risk of the cash flows. Since the project is in the more systematically risky manufacturing industry, the high WACC of a similar manufacturing firm should be used, not the low WACC of the retail firm which has less systematic risk.

Additionally, discounting by the WACC after tax only works if the firm always has the same proportion of debt. If the debt-to-assets ratio changes then the amount of tax shields will change and the after-tax WACC must be recalculated every year.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

Because the company's new projects are of similar systematic risk to the company's existing projects, the systematic risk of the assets will be constant. Therefore the WACC before tax, also called the required return on assets or the cost of capital, which takes only the time value of money and systematic risk into account, should remain the same, so answer (e) is correct.

Since the company is issuing equity, the leverage ratios will fall, not rise, so (a) and (b) are incorrect.

Because no more debt is being issued, the value of the firm's interest tax shields will remain constant. Therefore the value of the firm will not increase due to interest tax shields, so answer (c) is incorrect. However, the value of the firm will increase if the new projects are positive NPV.

The firm's after-tax WACC is likely to increase since there will be proportionally less interest tax shields because equity is increasing but debt is constant. So there will be a lower weight on the after-tax cost of debt ##\left(r_D.(1-t_c)\right)##. Therefore answer (d) is incorrect.

Note that the WACC's before and after tax take the time value of money and the systematic risk of the project into account. But the WACC after tax also takes interest tax shields into account as well. This is why the after-tax WACC rises when the proportion of equity funding rises because the proportion (or weight) of debt funding and thus interest tax shields falls.

Therefore the higher the weight of debt ##(D/V_L)##,

• The lower the after-tax WACC.
• No effect on the before-tax WACC, it is independent of capital structure.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

The key thing to realise in this question is that when house prices fall by 10%, there is no fall in the debt owing. The bank will not take pity and reduce the loan!

In the below table, 'k' means thousand. Filling in the values for all except the equity value at t=1, we can calculate that E = V - D = 360k - 320k = 40k, so equity should be 40k.

Asset, Debt and Equity Values
Millions of dollars
Time	V	D	E
0	400k	320k	80k
1	360k	320k	40k

 

The fall in equity from 80k (=400k-320k) to 40k (=360k-320k) corresponds to a 50% fall in equity:

###\begin{aligned} r_{\text{E, }0\rightarrow1} &= \frac{p_1-p_0+c_1}{p_0} \\ &= \frac{40k-80k+0}{80k} \\ &= \frac{-40k}{80k} \\ &= -0.5 = -50\% \\ \end{aligned} ###

Answer: Good choice. You earned $10. Poor choice. You lost $10.

The key thing to realise in this question is that when house prices fall by 15%, the bank will not take pity and reduce the debt owing.

In the below table, 'm' means million. Remembering that V=D+E and filling in the values for all except the equity value at t=1, we can calculate that E = V - D = 0.85m - 0.9m = -0.05m, so equity should be -0.05m which is -$50,000. Therefore the poor borrower has negative equity or negative wealth.

Asset, Debt and Equity Values
Millions of dollars
Time	V	D	E
0	1	0.9	0.1
1	0.85	0.9	-0.05

 

The fall in equity from $0.1m (=1m-0.9m) to -0.05m (=0.85m-0.9m) corresponds to a 150% fall in equity:

###\begin{aligned} r_{\text{E, }0\rightarrow1} &= \frac{p_1-p_0+c_1}{p_0} \\ &= \frac{-0.05m-0.1m+0}{0.1m} \\ &= \frac{-0.15m}{0.1m} \\ &= -1.5 = -150\% \\ \end{aligned} ###

Negative wealth is very unfortunate. Many people would declare themselves bankrupt (or for a company, insolvent) because there is no point paying off a house worth less than the value of the loan. However there are costs and limitations on people who are bankrupt for 5 years in Australia and 2 years in America, which is designed to deter bankruptcy. If the person decided to declare bankruptcy, his change in net wealth would be -100%. But in this question we must assume that he will pay his debts, therefore his change in net wealth is -150%.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

Statement (i) is true according to Miller and Modigliani's theories of capital structure and payout policy irrelevance.

Statement (ii) is true according to the CAPM because idiosyncratic risk is irrelevant since it can be diversified away when combined with a large portfolio of assets.

Statement (iii) is false according to the CAPM. Non-diversifiable systematic risk is rewarded with a higher return. This is the basis of the CAPM SML equation, expected return increases with beta:

###\begin{aligned} \mu_i &= r_f + \beta_i(\mu_m-r_f) \\ \end{aligned} ###

Answer: Good choice. You earned $10. Poor choice. You lost $10.

As a firm's amount of debt funding falls, the benefits of interest tax shields fall and the costs of financial distress also fall.

Debt leads to interest expense and therefore lower before-tax profits and lower tax payments which is the benefit of 'interest tax shields'.

Debt also leads to higher costs of financial distress since coupon and principal payments on bonds or loan payments must be made or else the firm will be insolvent and cease to exist. The costs of financial distress include:

• Employees leaving to work for competitors before they lose their job when the firm goes bankrupt.
• Customers not buying from the firm for fear that their warranty or after-sales service will not exist if the firm goes bankrupt.
• Suppliers will not grant generous credit terms for fear that the firm goes bankrupt and will not pay its debts.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

In a capital restructure where debt is issued to replace equity:

• The gearing ratios ##(D/V_L)## and ##(D/E_L)## increase , so statement (a) is true.
• Less taxes are paid due to higher interest expense and therefore lower before-tax profit, so statement (b) is true. ###\text{Corporate Tax}=(Rev-COGS-FC-Depr-\mathbf{IntExp}).t_c###
• Net income (NI) falls for the same reason as above, so statement (c) is true. ###NI=(Rev-COGS-FC-Depr-IntExp).(1-t_c)###
• Levered firm free cash flow (FFCF), same as levered cash flow from assets (CFFA) increases due to higher interest tax shields, so statement (d) is true. ###\begin{aligned} FFCF &= NI+Depr-CapEx - \varDelta NWC+IntExp \\ &= (Rev-COGS-FC).(1-t_c)+Depr.t_c - CapEx - \varDelta NWC + \mathbf{IntExp.t_c} \\ \end{aligned}###
• Equity free cash flow (EFCF, also called cash flow to equity) is not likely to stay the same, so statement (e) is false.

EFCF is the FFCF less net payments to debt holders (coupons and principal payments less debt raisings). This should also equal the dollar value of dividends and buybacks less equity raisings.

###\begin{aligned} EFCF &= \text{dividend payments} + \text{buybacks} - \text{equity raisings}\\ &= FFCF - \text{debt cash flows} \\ &= FFCF - (\text{coupon payments} + \text{principal repayments} - \text{debt raisings}) \\ \end{aligned}###

Equity free cash flow (EFCF) may increase for the same reason as firm free cash flow (FFCF) increases: the higher amount of interest tax shields, which means more money is available to pay dividends and undertake buy backs.

Or cash flow to equity could fall because there is less equity to actually pay after the debt raising and equity buy-back. On the other hand, the systematic risk of the remaining equity will be higher since there is more leverage, so the total required return of equity will be higher. But this higher total return could be achieved by capital gains in the share price (not included in EFCF) or dividends and buy-backs (part of EFCF), so there won't necessarily be an increase in EFCF if higher capital gains are realised.

The equity free cash flow is also affected by the coupon and principal payments to debt holders. Note that coupon payments are not necessarily equal to interest expense (IntExp), since accountants define interest expense according to the 'effective interest method' which is yield times book value of debt at the start of the year, so even zero-coupon bonds have interest expense.

Note that the cash flow to equity holders will be very high during the time when the equity is bought back, because clearly this will be a large equity buy-back. But the question is asking how the cash flow to equity will change after the capital restructure, not during the restructure.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

Negative gearing allows investment income losses to be deducted from personal income, saving personal income tax. This is a form of interest tax shield at the personal level.

Real estate investment income is calculated as net rental income (which doesn't include unrealised capital gains) less mortgage loan interest expense. When this is negative, it is allowed to be deducted from pre-tax personal income which results in the personal income interest tax shield and is called 'negative gearing'.

Note that this is an unusual tax policy because usually, losses in one business (real estate investment) are not allowed to be offset against profits in another businesses (your personal income). Normally, losses in one business become 'carry-forward tax losses' that may be deducted from future before-tax profits earned by that business only.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

A firm's managers should not try to achieve a particular pattern of equity payout, or diversify the firm's cash flow across industries. This is because of home-made or DIY payout and diversification. Shareholders can easily achieve a particular payout policy themselves, for example by selling a small amount of stocks in a non-dividend paying firm to replicate a dividend, or re-investing dividends to replicate a capital gain. Shareholders can also easily diversify across industries by purchasing stocks in those industries.

But managers should try to maximise shareholders' wealth since that is supposed to be their main aim. Ans they should try to minimise agency costs such as perks, paying themselves too much and not working hard since that reduces shareholder wealth.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

Beta (##\beta##) is a measure of systematic risk.

Since the value of the firm's assets must equal the value of its debt and equity,###V=D+E### The firm's assets' beta must equal the weighted average beta of the debt and equity, so: ###\beta_V = \frac{D}{V}\beta_D + \frac{E}{V}\beta_E###

In this question, there is no change in the firm's assets. Therefore, all things remaining equal, there shouldn't be any change in the beta of the firm's assets (##\beta_V##).

Since the firm is issuing more debt by borrowing in the form of a loan or a bond, the amount of debt will increase (↑ D). The funds raised from the debt are being used to repurchase equity, so the amount of equity will decrease (↓ E).

Equity holders have a residual claim on the firm's assets, which means that they get paid last if the firm goes bankrupt. So shareholders get paid after debt holders. Therefore the increase in the amount of debt means that the equity holders are less likely to receive any money if the firm goes bankrupt. It also means that there will be a larger amount of interest payments that the firm must meet so there is a higher chance of going bankrupt. This means that equity must have more systematic risk, so it's beta will increase (↑##\beta_E##). This is the answer.

Also note that since there are more debt-holders, the larger amount of debt also has more systematic risk (↑##\beta_D##). This may appear impossible since how can the beta on debt and equity rise, while the beta on assets remain constant? But this is possible since the beta on debt is always less than the beta on equity (##\beta_D < \beta_E##), and while both betas rise, there is a larger weight on debt (↑##\frac{D}{V}##), and a lower weight on equity (↓##\frac{E}{V}##), so the asset beta stays the same.

To summarise: ###\begin{matrix} \cdot \\ \beta_V \\ \end{matrix} \begin{matrix} \phantom{1} \\ = \\ \end{matrix} \begin{matrix} \uparrow \\ \frac{D}{V} \\ \end{matrix} \begin{matrix} \uparrow \\ \beta_D \\ \end{matrix} \begin{matrix} \phantom{1} \\ + \\ \end{matrix} \begin{matrix} \downarrow \\ \frac{E}{V} \\ \end{matrix} \begin{matrix} \uparrow \\ \beta_E \\ \end{matrix}###

Answer: Good choice. You earned $10. Poor choice. You lost $10.

The WACC before tax, also known as the opportunity cost of capital or the required return on assets (##r_{VL}##), will decrease when the firm's systematic risk decreases. This is because the WACC before tax takes the time value of money and the systematic risk into account. This is apparent when you consider the two different ways to calculate the WACC before tax.

There is the familiar formula which is the weighted average cost of the equity and debt used to finance the firm's assets:

###r_\text{WACC before tax} = r_{VL} = {r_D.\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L}}###

Since ##V=D+E##, this should be equal to the required return on the firm's assets using the CAPM with the firm's asset beta:

###r_\text{WACC before tax} = r_{VL} = {r_f} + \beta_{VL}(r_m - r_f)###

This CAPM version of the WACC before tax equation breaks the required return into the time value of money (##r_f##) and the systematic risk premium (##\beta_{VL}(r_m - r_f)##).

Clearly, the lower the levered asset beta (##\beta_{VL}##), the lower the WACC before tax.

Note that the WACC before tax is not affected by tax shields, unlike the WACC after tax. Therefore an increase in debt and tax shields (answer c) or a decrease (answer d) will have no effect. But the WACC after tax will decrease and increase respectively.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

The firm's assets' systematic risk (or market risk, measured by beta) remains the same so the firm's pre tax WACC (or required return on assets) will also be unchanged.

All that has changed is the way that the assets are funded. There will be more debt and less equity. This will create a larger interest tax shield which leads to higher levered cash flow from assets and a lower after tax WACC.

Note also that with proportionally more debt the amount of leverage is increasing so ##D/V## and ##D/E## will increase. The cost of equity will be higher since there will be more creditors who get paid first before the equity holders. Equity holders' residual claim on the firm's assets is made more junior when the amount of debt increases.

Answer: Good choice. You earned $10. Poor choice. You lost $10.

Beta (##\beta##) is a measure of systematic risk, along with variance (##\sigma^2##) and standard deviation (##\sigma##) .

Since the firm's assets (V) are funded by debt (D) and equity (E), the systematic risk of the firm's assets equals the weighted average beta of the debt and equity, so: ###\beta_V = \frac{D}{V}\beta_D + \frac{E}{V}\beta_E###

In this question, there is no change in the firm's assets. Therefore, all things remaining equal, there shouldn't be any change in the beta of the firm's assets (##\beta_V##).

Since the firm is issuing more equity (using a rights issue or private placement for example) and using the funds to repay debt (paying back the bond or loan-holders), the amount of equity will increase (↑ E) and the amount of debt will decrease (↓ D).

Equity holders have a residual claim on the firm's assets, which means that they get paid last if the firm goes bankrupt. So shareholders get paid after debt holders. Therefore the decrease in the amount of debt means that the equity holders are more likely to receive some payment if the firm goes bankrupt. It also means that there will be a smaller amount of interest payments that the firm must meet so there is a lower chance of going bankrupt. This means that equity must have less systematic risk, so it's beta will fall (↓##\beta_E##). This is the answer.

Also note that since there are less debt-holders, the smaller amount of debt also has less systematic risk (↓##\beta_D##). This may appear impossible since how can the beta on debt and equity fall, while the beta on assets remain constant? But this is possible since the beta on debt is always less than the beta on equity (##\beta_D < \beta_E##), and while both betas fall, there is a lower weight on debt (↓##\frac{D}{V}##), and a higher weight on equity (↑##\frac{E}{V}##), so the beta on assets stays the same.

To summarise: ###\overbrace{\beta_V}^{\cdot} = \overbrace{\frac{D}{V}}^{\downarrow} \overbrace{\beta_D}^{\downarrow} + \overbrace{\frac{E}{V}}^{\uparrow} \overbrace{\beta_E}^{\downarrow} ###

Answer: Good choice. You earned $10. Poor choice. You lost $10.

The value created by having more debt, more interest expense and therefore paying less tax will increase the value of the firm's levered assets (##V_\text{Levered}##).

###V_\text{Levered}=V_\text{Unlevered} + V_\text{Interest Tax Shields}###

This increase in asset value makes the equity (shares) more valuable, so share prices rise. But strangely, the higher share prices should have no effect on shareholder wealth, according to the theory by Miller and Modigliani. This is because shareholders can achieve interest tax shields themselves.

For example, an investor who buy shares in an unlevered firm can increase leverage and tax shields by funding the shares using an investment loan, deducting the interest expense from the shares' dividends and capital gain income, reducing personal tax payable.

On the flip side, a shareholder in a levered firm can decrease leverage and tax shields by selling some of the shares and lending the money to a bank, adding interest income to the shares' dividend and capital gain income, increasing personal tax payable.

So shareholders can achieve their ideal amount of leverage, regardless of whether the firm is levered or not. This optimum is achieved by shareholders weighing up the benefits of tax shields against their risk-tolerance and costs of financial distress.

Therefore the company's effort to lever up and create more tax shields is pointless since shareholders are already optimally geared and do not want any more leverage and tax shields, or else they would have already done it themselves. When the company increases its leverage, the shareholders would decrease their personal leverage (and personal interest tax shields) to remain optimally levered. The net effect is that shareholders' overall leverage and interest tax shields are unchanged.

As a side note: although the share price is expected to increase due to the company's higher interest tax shields, the market capitalisation of equity (E) will fall overall since the number of shares will fall. This is because of the share repurchase which is where the company buys back shares from shareholders and cancels them. This fall in equity (E) will be accompanied by an increase in debt (D). The debt issue will fund the equity repurchase.