Question

Taco Salad Manufacturing, Inc., plans to announce that it will issue $2.27 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 8 percent. The company is currently all-equity and worth $6.74 million with 210,000 shares of common stock outstanding. After the sale of the bonds, the company will maintain the new capital structure indefinitely. The annual pretax earnings of $1.51 million are expected to remain constant in perpetuity. The tax rate is 23 percent.

a. What is the expected return on the company’s equity before the announcement of the debt issue? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

d. What is the company’s stock price per share immediately after the repurchase announcement? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

e-1. How many shares will the company repurchase as a result of the debt issue? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

e-2. How many shares of common stock will remain after the repurchase? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

g. What is the required return on the company’s equity after the restructuring? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

(a) Planned Perpetual Debt = $ 2.27 million, Coupon Rate = 8 % , All Equity Financed Firm Worth = $ 6,74 million, Number of Shares Outstanding = N = 210000, Annual Pre-Tax Earnings = $ 1.51 million

As the debt is issued at par the debt's coupon rate equals the cost of debt (interest expense rate)

Tax Rate = 23 %

Earnings Before Tax (EBT) = $ 1.51 million

Less: Tax Expense = 0.23 x 1.51 = $ 347300

Net Income = $ 1162700

Firm Value = Equity Value = $ 6.74 million  

Return on Equity = 1162700 / 6740000 = 0.172507 or 17.2507 % ~ 17.25 %

(d) After repurchase announcement, the firm value immediately increases by the amount of the interest tax shield to be generated by the debt being raised.

Debt Raised = $ 2.27 million and Interest Rate = 8 %

Interest Expense = 2.27 x 0.08 = $ 0.1816 million

Interest Tax Shield = Interest Expense x Tax Rate = 181600 x 0.23 = $ 41768

PV of Interest Tax Shield = PV(ITS) = 41768 / 0.08 = $ 522100

Total Firm Value post Announcement = All Equity Firm Value + PV(ITS) = 6740000 + 522100 = $ 7262100

Price Per Share = 7262100 / 210000 = $ 34.58

(e1) Debt Issued = $ 2270000 and Price Per Share = $ 34.58

Number of Shares Repurchased = 2270000 / 34.58 = 65642.1696 ~ 65642.17

(e2) Number of Shares Remaining = 210000 - 65642.17 = 144357.83

(g) Earnings Before Tax and Interest (EBIT) = $ 1510000

Less: Interest Expense = 2270000 x 0.08 = $ 181600

Profit Before Tax (PBT) = $ 1328400

Less: Tax Expense = 0.23 x 1328400 = $ 305532

Net Income = $ 1022868

New Firm Value = $ 7262100 and Debt Issued = $ 2270000

Equity Value = 7262100 - 2270000 = $ 4992100

Return on Equity = (1022868 / 4992100) x 100 = 20.4897 % ~ 20.49 %