Question

Magic Production Company (MPC) is considering a recapitalisation plan that would convert MPC from its current all-equity capital structure to one including some financial leverage. MPC now has 6 million ordinary shares outstanding, which are selling for $50.00 each. Currently, MPC shareholders have a required return of 15%. The expected earnings before interest and taxes (EBIT) of MPC is $45,000,000 per year for the foreseeable future.

The recapitalisation proposal is to issue $100,000,000 worth of long-term debt at an interest rate of 7.5 per cent and use the proceeds to repurchase as many shares as possible at a price of $50.00 per share. Assume there are no market frictions such as corporate or personal income taxes.

a. Calculate the number of shares outstanding and the debt-to-equity ratio for MPC if the proposed recapitalisation is adopted.

b. Calculate the expected earnings per share (EPS) and the expected return on equity (ROE) for MPC shareholders under the proposed mixed debt/equity capital structure. How does it compare to the EPS and ROE under the current capital structure?

c. Calculate the break-even level of EBIT where earnings per share for MPC shareholders are the same under the current and proposed capital structures.

For the next question assume Magic Production Company (MPC) is subject to a 40% corporate income tax rate.

How does financial leverage increase the value of MPC in the presence of corporate income taxes? Explain.

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Answer 1

a	Outstanding shares	6000000
	Share price	50
	Equity before	300000000
	7.5%Debt	100000000
	No of shares repurchase	100000000/50
		2000000
	Remaining shares	4000000
	Equity	200000000
	Debt to equity	Debt / equity
		0.5
		Proposed	Present
b	EBIT	45000000	45000000
	Interest	7500000
	Profit	37500000	45000000
	Taxes	15000000	18000000
	Net profit	22500000	27000000
	No of shares	4000000	6000000
	EPS	5.625	4.5
	ROE	Net profit/equity
		11.25	9
c	Let the EPS under proposed method is same as current
	(EBIT-int)*0.60 = EBIT*0.60
	4000000                    6000000
	(EBIT-7500000)*0.60     =    0.60EBIT
	4000000	6000000
	(0.60EBIT - 4500000)*6000000 = 0.60EBIT *4000000
	Breakeven	EBIT = 22500000