An all equity firm is expected to generate perpetual EBIT of $100 million per year forever....

An all equity firm is expected to generate perpetual EBIT of $100 million per year forever. The corporate tax rate is 35%. The firm has an unlevered (asset or EV) Beta of 0.8. The risk-free rate is 4% and the market risk premium is 6%. The number of outstanding shares is 10 million.

1. The firm decides to replace part of the equity financing with perpetual debt. The firm will issue $100 million of permanent debt at the riskless interest rate of 4%, and use this $100 million of proceeds to repurchase the same amount of common stock.

A. Find the new value of the levered firm following this capital structure change.

B. Find the new number of shares outstanding, and the new share price.

Solutions

Expert Solution

A. Find the new value of the levered firm following this capital structure change

Unlevered Beta = 0.8

Risk Free Rate = 4%

Market Risk Premium = 6%

Required Return = Risk Free Rate + (Beta*Market Risk Premium) = 4% + (0.8*6%) = 4%+4.8% = 8.8%

Perpetual EBIT = $100 Million

Tax rate = 35%

Free Cash Flows (Earnings after tax) = $100 Million * (1-35%) = $65 Million

Value of the firm (unlevered firm) = Free Cash Flows / Required return = $65 Million / 8.8% = $738.64 Million

Under Modigliani Miller Theory, Value of the unlevered firm equals value of the levered firm and capital structure does not change the value of the firm.

Thus, value of the firm after the capital structure change= $738.64 Million

B. Find the new number of shares outstanding, and the new share price.

New number of shares outstanding = Number of shares of unlevered firm - Shares repurchased

Number of shares of unlevered firm = 10 Million

Shares Repurchased = $100 Million / Value per share

Value per share = Value of the firm (unlevered) / shares outstanding = $738.64 Million / 10 Million = $73.86 per share

Thus, Shares repurchased = $100 Million / $73.86 = 1,353,913 shares

Hence, New number of shares outstanding = 10 Million - 1,353,913 = 8,646,087 shares

New share price:

Value of the firm = $738.64 Million

Value of Debt = $100 Million

Thus, value of equity = $738.64 Million - $100 Million = $638.64 Million

New Share Price = Value of Equity / New number of shares outstanding = $638.64 Million/8,646,087 shares = $73.86

jeff jeffy answered 1 year ago

Next > < Previous

Related Solutions

Omega Co. is an all-equity firm that is expected to generate EBIT of $8 million every...

Omega Co. is an all-equity firm that is expected to generate EBIT of $8 million every year forever. The company is now considering issuing debt with the amount of half the company's current value at a rate of 10%. There are currently 2 million shares outstanding. The proceeds will be used to repurchase equity. The firm's current cost of capital is 20% and corporate tax rate is 40%. 1. what is the current price per share? (before restructuring) 2. what...

Stevenson's Bakery is an all-equity firm that has projected perpetual EBIT of $198,000 per year. The...

Stevenson's Bakery is an all-equity firm that has projected perpetual EBIT of $198,000 per year. The cost of equity is 14.1 percent and the tax rate is 34 percent. The firm can borrow perpetual debt at 5.8 percent. Currently, the firm is considering converting to a debt–equity ratio of 1.08. What is the firm's levered value?

DIY has EBIT of $4 million per year forever. Its cost of equity is 12% and...

DIY has EBIT of $4 million per year forever. Its cost of equity is 12% and tax rate is 40%. There are 1.2 million shares outstanding. It also has $8 million (face value) perpetual debt which pays annual coupon of 5%, and is trading at 125% of the face value. DIY wants to borrow new perpetual debt of $2 million at current cost of debt to buy back its common stocks. Due to this new debt, there will be present...

DIY has EBIT of $4 million per year forever. Its cost of equity is 12% and...

Southwest Airlines is an all-equity firm, with a perpetual EBIT of $153.85. The firm is considering...

Southwest Airlines is an all-equity firm, with a perpetual EBIT of $153.85. The firm is considering to issue $200 worth of debt with an interest rate of 10% and use the proceeds to buyback its shares. The tax rate is 35%. Assume the firm has a current required return of 20% and all earnings are returned to shareholders as dividends after taxes. What will the value of the airlines be after the debt issuance? What is Southwest Airlines’ cost of...

Pearson, Inc. is 100% equity financing and has an expected perpetual EBIT of $380,000. The firm's...

Pearson, Inc. is 100% equity financing and has an expected perpetual EBIT of $380,000. The firm's cost equity is 11%. The firm is considering issuing $1, 200,000 in new par bonds to financial leverage to the firm. The proceeds of the debt will be used to repurchase equity. The cost of debt is s% and the tax rate is 30 percent (a) What is the value of the firm under current capital structure of 100% equity financing? (b) What will...

Floundering Fish Ltd. Is an all equity firm with EBIT of $950,000 per year which will...

Floundering Fish Ltd. Is an all equity firm with EBIT of $950,000 per year which will continue forever as the company pays out all earnings in the form of dividends. T-bills are currently yielding 2%; the market risk premium is 5%; the company’s tax rate is 40%; and costs of financial distress apply. Assume the market value of debt is equal to its book value. Beta of all equity firm is 0.85. What would be the value of the company...

GRK Co. is currently an all-equity firm with an expected return of 10%. The expected EBIT...

GRK Co. is currently an all-equity firm with an expected return of 10%. The expected EBIT is $ 50,000 forever. Assume that the firm distributes all the net income to the equity holders. The firm is considering a leveraged recapitalization in which it would borrow $ 250,000 and repurchase existing shares. The firm's tax rate is 40%. The cost of debt is 7%. 1/ Calculate the value of the firm with leverage. 2/ Calculate the expected return of equity after...

Pokie Industries, Inc (PII) is expected to generate perpetual EBIT of $2,100. If PII had no...

Pokie Industries, Inc (PII) is expected to generate perpetual EBIT of $2,100. If PII had no debt in its capital structure, its (unlevered) stockholder required return would equal 14 percent. (The corporate tax rate for the firm is 35 percent.) PII, however does have $3,000 of debt, and that debt has a a 6 percent coupon and sells at par. Assume the M&M theory of capital structure is valid. What is the value of this firm?

Lion Corp is an all equity firm. The firm's annual EBIT is currently $10 million and...

Lion Corp is an all equity firm. The firm's annual EBIT is currently $10 million and is expected to remain at that level indefinitely. The current expected return on Lion's stock is 20% and the firm pays corporate tax at the 35% rate. (a) Calculate the current value of Lion Corp. as an unlevered firm. (b) Suppose that Lion sells $10 million in debt and repurchases $10 million in equity. The debt they issue will offer a 10% interest rate....

Subjects