Question

Suppose that American Eagle Outtters, headquartered in SouthsideWorks, is financed solely by common stock. It has 170 million shares outstanding at a price of $18 per share. It announces that it intends to issue $1 billion of debt and use the proceeds to buy back common stock. The debt beta will be zero. The risk-free rate is 2%, the expected return on the market portfolio is 9.7%, and American Eagle Outtters's asset beta is 1.2.

(a) How is the market price of its stock affected by the announcement?

(b) How many shares can the company buy back with the $1 billion of new debt that it issues?

(c) What is its firm value before and after the change in its capital structure?

(d) What is American Eagle Outtters' debt ratio after the change in its capital structure?

(e) What is its cost of equity after restructuring?

Answer 1

Information about the common stock:

1. No. of outstanding Shares = 170,000,000
2. Price of the Stock = $18
3. Therefore, Market Cap of American Eagle = 170,000,000*$18 = $3,060,000,000

a) Initially, the share price, post buyback announcement might increase as the end result of a buyback would mean a higher EPS (Earning Per Share) for the stockholder. However, in the long term, the buyback is only beneficial if it happens at a price lower than the stock's intrinsic value i.e when the stock is actually undervalued.

b) If we assume that the average price of buyback is $18, the company will be able to buy approximately 55,555,555 (=1,000,000,000/18) shares. If the average price of the buyback if different, simply divide $1billion with the average buyback price for the no of shares that the company has bought back.

c) The Firm Value will remain the same - if the stock price stays at $18. Basically, firm value is the addition of market value of equity and debt. In a buyback scenario, the market cap is reducing (market value of equity will decrease), however, at the same time, the share of debt will increase by the same amount. The firm had no debt initially and was a pure equity firm with market cap of $3.06 billion. Now, after the buyback, the firm value will be the same, however equity will be $2.06 billion and debt will be $1 billion.

d) Debt Ratio is calculated as Total Liabilities or Debt/Total Assets. Total Assets is equal to Liabilities + Equity. Hence, the debt ratio will be $1 billion / $ 3.06 billion = 32.67%. Initially, before the debt issue this ratio was 0, as the company was debt free.

e) Cost of Equity can be calculated using CAPM i.e Re = Rf + (beta*(Rm-Rf)), where Rm is the return on market portfolio, Rf is the risk free rate, Re is the cost of equity.

• Here, we know Rf = 2%, Rm = 9.7%, beta = 1.2
• So, Re = 2% +(1.2*(9.7%-2%)) = 2% + 9.24% = 11.24%