Question

Caviar Fishfarm Ltd (‘CFL’) is unlevered, has an equity beta of 1.25 and unlevered cash flows of $76,800 per annum that will continue in perpetuity. The expected market return is 10%p.a and Treasury bills earn 2%p.a. CFL is currently considering issuing $300,000 in new debt with an 8% interest rate. CFL would repurchase $300,000 of its own shares, using the proceeds of the debt issue. There are currently 32,000 shares outstanding and the company’s effective marginal tax rate is 34%. Assuming it is certain that the company completes the restructure, calculate the value of each share in the company, after the restructure (ignore other information effects). (in dollars to nearest cent)

Answer 1

Step 1: Calculating the value of unlevered firm

Since firm is unlevered , hence equity beta = unlevered beta = 1.25, Risk free rate = T bill interest rate = 2% p.a.

Market return = 10%

According to CAPM

Unlevered cost of equity = Risk free rate + unlevered beta (market return - risk free rate) = 2% + 1.25 (10% - 2%) = 2% + 1.25 x 8% = 2% + 10% = 12% p.a.

Perpetual Annual unlevered cash flows = $76800

We know that Present value of perpetuity = Annual Cash flow / discount rate

Using the the above formula we get,

Value of unlevered firm = Present value of unlevered cash flows discounted at unlevered cost of equity = Unlevered cash flow / Unlevered cost of equity = 76800 / 12% = $640000

Step 2 Calculating the present value of interest tax shield discounted at cost of debt

Interest tax shield = Debt x interest rate x tax rate = 300000 x 8% x 34% = 8160

Once the firm becomes levered by issuing debt then after that debt is constant, so interest tax shield will also form a perpetuity

Present value of interest tax shield = Interest tax shield / Cost of debt= 8160 / 8% = 102000

Step:3 Calculating value of firm or levered firm after debt is issued

We know that

Value of a firm = Value of levered firm = Value of unlevered + Present value of interest tax shield = 640000 + 102000 = $742000

Step 4 : Calculating value of a share after restructuring

Value of equity = Value of firm - Value of debt = 742000 - 300000 = 442000

Value of a share = Value of equity / No of shares = 442000 / 32000 = 13.8125 = 13.81 (rounded to nearest cent)

Hence Value of each of company after restructuring = $13.81