Question

Firm C currently has 250,000 shares outstanding with current market value of $42.00 per share and generates an annual EBIT of $1,250,000. Firm C also has $1 million of debt outstanding. The current cost of equity is 8 percent and the current cost of debt is 5 percent. The firm is considering issuing another $2 million of debt and using the proceeds of the debt issue to repurchase shares (a pure capital structure change). It is estimated that the cost of the new debt will be 5.5 percent and that the cost of equity will rise to 8.48 percent with the additional debt. The marginal tax rate is 30 percent.

a. What will the estimated new share price be after the capital structure change announcement?

b. How many shares are outstanding after the repurchase?

Answer 1

Earning after taxes after new Debt issue = EBIT - Interest - taxes

= 1,250,000 - (1000,000 * 0.05 + 2,000,000 * 0.055) - 30% * (1,250,000 - (1000,000 * 0.05 + 2,000,000 * 0.055))

= 763000

Market Value = Earnings After taxes / New Cost of Equity

= 763000 / 0.0848

= 8,997,641.51

Value of Firm = 8,997,641.51 + 3,000,000

= 11,997,641.51

Answer a)

New Share Price will be as follows = Value of Firm - old Debts / Oustanding shares

=11,997,641.51 - 1,000,000 / 250,000

= 44

Answer b)

No of shares to be repurchased = 2,000,000 /44 = 45464

no of share after repurchase = 250,000 - 45464 = 204,536