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. 1) What will the estimated new share price be after the capital structure change announcement? 2) How many shares are outstanding after the repurchase

Answer 1

1)

Here first we have to calculate Market value of firm after capital structure change

New interest = (Existing debt * interest rate) + (new debt * interest rate)

= (1,000,000 * 5%) + (2,000,000 * 5.5%)

= 160,000

Given EBIT = 1,250,000

EBT = EBIT - Interest

= 1,250,000 - 160,000

= 1,090,000

EAT = EBT*(1 - tax)

= 1,090,000*(1 - 30%)

= 763,000

Market value of equity = EAT / Cost of Equity

= 763,000 / 8.48%

= 8,997,642

Market value = Equity + Debt

= 8,997,642 + 3,000,000

= 11,997,642

So Estimated new share price = (11,997,642 - 1,000,000) / 250,000

= $44

2)

New debt to be issued = 2,000,000

share price = 44

so number of shares to be repurchased = 2,000,000 / 44 = 45,464

New shares = (existing shares - shares to be repurchased)

250,000 - 45,464 = 204536 shares