Question

CAPITAL STRUCTURE, PAYOUT POLICY AND COST OF CAPITAL

Pharma-C is a pharmaceutical firm that manufactures and sells a portfolio of blockbuster drugs at high margins. The firm is all-equity financed and has 40 million shares outstanding at a price of $75 per share. Pharma-C’s current cost of capital is 7.5%. The firm is considering to buy back $400 million in shares in the open market and to finance the repurchase by issuing bonds. Pharma-C plans to maintain this capital structure indefinitely. At this level of debt, the bonds would be A-rated, and the firm would pay an interest rate of 4.5%. Pharma C’s- marginal corporate tax rate is 25%. With this information answer the following three questions.

1. Calculate the stock price of Pharma-C when the share repurchase plan is announced to the market, and also determine how many shares the firm would need to repurchase. Clearly describe your approach.
2. Determine Pharma-C’s cost of equity and its cost of capital after the share repurchase and explain the directional change for both.
   
3. Now suppose that the stock price upon announcement of the share repurchase plan equals $77.90. If we assume that the market is efficient, and the firm has not released any other information, what can you infer from this regarding the market’s assessment of Pharma-C’s cost of financial distress, and how would you estimate these costs? Motivate your approach and discuss the inputs in any calculations.
   

Answer 1

Here, The concept of WACC ,

By using of WACC , WACC =

Number of share	40000000
Price of share	$75.00
Total capital	$3,000,000,000.00
Value of buy back	$400,000,000.00
Number of share buy back	$5,333,333.33
Remaining shares	34666666.67
Value of share capital	$2,600,000,000
weighted value of share capital	0.866666667
weighted value of debt capital	0.133333333

WACC in the case: All equity , WACC = cost of equity = 7.5%

New case after buy back , WACC = 0.867*7.5%+ 0.133*4.5%(1-0.25) =6.951%

As the market is efficient , the new price of share will be $ 77.90.

Number of share	40000000
Price of share	$77.90
Total capital	$3,116,000,000.00
Value of debt	$400,000,000.00
Number of share buy back	5134788.19
Remaining shares	34865211.81
Value of share capital	$2,716,000,000
weighted value of share capital	0.871630295
weighted value of debt capital	0.128369705

Weighted average cost of debt by use WACC equation

WACC = 0.872 *7.5% + 0.128*W_d *(1-0.25)

=> W_d = 4.285%