Question

Taco Salad Manufacturing, Inc., plans to announce that it will issue $2.37 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 5 percent. The company is currently all-equity and worth $6.84 million with 220,000 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 $1.61 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.) b. What is the price per share of the company's equity? (Do not round intermediate calculations and round your answer 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)

Given

Pretax Annual Earnings = 1.61 Million $

Less: Tax @ 23% = - 0.3707 Million $

Net Income = 1.2397 Million $

Equity Worth = 6.84 Million $

Expected Return on Equity = Net Income / Equity Worth = 1.2397/6.84 = 0.181243

Therefore expected return on equity before announcement of debt= 18.12%

(b)

Given Equity Worth = 6.84 Million $

Number of Shares = 220,000 shares

Price Per Share = Equity Worth / Number of Shares = 6840000/220000 = 31.09091

Price of Equity Share = 31.09 $ per share.

(d)

Debt Issue = 2,370,000$ = Bought Back Amount of Equity

Equity Price Per Share = 31.09

Number of shares bought back = 2370000/31.09 = 76230.2991 Shares

Total Number of shares outstanding = Number of shares present before bought back - Number of shares bought back

= 220000 - 76230

= 143,770 shares

after Buy Back Equity worth will be same, but number of shares decreases

Price of share = Equity Worth / Number of shares outstanding = 6840000/143770 = 47.5760$

Therefore Price per share after buying back = 47.58$

(e)

Number of shares that will be repurchased = 76230 shares

(f)

Number of shares remain after restructuring would be 143,770 shares

(g)

Particulars	Amount
Earnings Before Interest and Tax	1610000
Less: Interest	-118500
Earnings Before Tax	1491500
Less: Tax @23%	-343045
Net Income	1148455

Equity Worth = 6.84 Million $

Expected return on equity = Net Income/Equity Worth = 1148455 / 6840000 = 0.16790

Therefore Expected Return on Equity = 16.79%