Question

Firm C currently has 320,000 shares outstanding with current market value of $33 per share and generates an annual EBIT of $1,500,000. Firm C also has $1 million of debt outstanding. The current cost of equity is 9 percent and the current cost of debt is 6 percent. The firm is considering issuing another $3 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 7 percent and that the cost of equity will rise to 10 percent with the additional debt. The marginal tax rate is 34 percent.

a. What is the current market value of the firm?

b. What will the firm’s market value be after the announcement of the new debt issue? (Note that total market value of debt will be D0 + D1 and the interest costs that must be subtracted from EBIT when calculating the market value of equity must be calculated in two parts and then added: Kd0D0 + Kd1D1).

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

d. How many shares are outstanding after the repurchase?

Answer 1

Part (a)

Current market value of the firm = market value of debt + market value of equity = $ 1 mn + Price per share x nos. of shares outstanding = 1,000,000 + 33 x 320,000 = $ 11,560,000

Part (b)

PAT = (EBIT - I) x (1 - T)

EBIT = $ 1,500,000

Interest, I = Kd0D0 + Kd1D1 = 6% x 1 mn + 7% x 3 mn = $ 270,000

T = 34%

Hence, PAT = (1,500,000 - 270,000) x (1 - 34%) = $811,800

Hence, market value of equity = PAT / Ke = 811,800 / 10% = $ 8,118,000

Market value of the firm = market value of equity + D0 + D1 = 8,118,000 + 1,000,000 + 3,000,000 = $ 12,118,000

Part (d)

Please note that the new debt of $ 3mn has not been issued yet.

the estimated new share price be after the capital structure change announcement = (Market value of the firm - market value of the existing debt) / Current outstanding number of shares = (12,118,000 - 1,000,000) / 320,000 = $ 34.74

Part (d)

Shares are outstanding after the repurchase = Current outstanding number of shares - shares repurchased = 320,000 - D1 / estimated new share price = 320,000 - 3,000,000 / 34.74 =  320,000 - 86,346.46 = 233,644