Question

We are given the following information about a Company X -

Debt-Value Ratio - 15%

Revenue - $90,000

Cost - $50,0000

Cost of Debt - 5%

Cost of Equity - 25%

Shares Outstanding - 5,000

Corporate Tax - 30%

(a) What is the firm’s value?

(b) What is its stock price?

(c) Company Y is a leveraged buyout firm. It believes that Company X's leverage is too low. It thinks that Company X's firm value can increase with higher debt-to-value ratio and believes Company X's optimal debt-to-value ratio is 15%. Company X's cost of debt at this 15% debt-to-value ratio is 9%. Company Y is considering buying all of Company X's shares and increase Company X's leverage to the optimal 15% level. Proceeds from debt issuance will be given out to equityholderes as special dividend. What is the maximum premium Company Y is willing to pay for Company X's shares?

Answer 1

A.

Given Information

debt value is 15% ,hence weight of debt is 0.15 and weight of equity is 0.85

Weighted average cost of capital = Cost of debt * Weight of debt + cost of Equity * weight of equity

WACC    = 5% * 0.15 + 25% * 0.85

   = 22 %

Value of the firm = Earnings / WACC

   = (Revenue - Cost) / WACC

= (90000-50000) / 22%

   = 40000 / 0.22

= 1,81,818

Equity Value    = Firm Value * Equity weight

   = 1,81,818 * 0.85

= 1,54,545

No of shares    = 5000

Share Price = Equity Value / No of shares

= 154545 / 5000

= 30.9090

c.

Given Information

debt value is 9% ,hence weight of debt is 0.09 and weight of equity is 0.91

Cost of debt = 15% assume that cost of Equity is same as 25%

Weighted average cost of capital = Cost of debt * Weight of debt + cost of Equity * weight of equity

WACC    = 15% * 0.09 + 25% * 0.91

   = 24.1 %

Value of the firm = Earnings / WACC

   = (Revenue - Cost) / WACC

= (90000-50000) / 24.1%

   = 40000 / 0.241

= 1,65,975

Debt Value = 165975 * 0.09 = 14,938

If debt value to be 15%, it has to issue up to 14938/0.09*0.15 = 24896

i.e,Debt Extra to be issued = 24896-14938 = 9959

Dividend for per Equity share = 9959/5000 = 1.992

Equity Value    = Firm Value * Equity weight

   = 1,65,975 * 0.91

= 1,51,037

No of shares    = 5000

Price per share = 151037/5000

   = 30.2075

Original Share price = 30.9090

Revised price = 30.2075

Excess premium paid = 0.7016