Question

ABC Golf Corporation Assignment:

ABC Golf Equipment Corporation has 500,000 shares outstanding and currently has no debt. The company has a marginal tax rate of 35% and the firm’s stock price is $27 per share. The firm’s unlevered beta is 1.5, the risk-free rate of return is 5%, and the expected market return is 10%.

The company is thinking of issuing bonds and simultaneously repurchasing a portion of its stock. Because the company is issuing bonds to repurchase the stock, there is no anticipated change to the stock price as a result of the stock buyback. The bonds can be issued with a 6% coupon, and under the new proposed structure the debt to capital ratio would be 7%. If the company’s debt to capital ratio exceeds 25%, the cost of debt would increase to a max rate of 8%. Company mandates require that the company’s debt to equity ratio remains at less than 3.0 at all times. The firm’s earnings are not expected to grow over time. All of its earnings will be paid out as dividends.

Probability	EBIT ($)
0.05	-$1 Million
0.25	2.3 Million
0.40	4 Million
0.25	5.8 Million
0.05	6.1 Million

Use Excel for your calculations and answer the ten questions on the following pages. Your submission should consist of two files:

1) Submit a Word document clearly showing your solutions and how you achieved them

2) Also if possible please submit an Excel worksheet showing your spreadsheets that you used to calculate solutions.

Questions to answer:

1) Based on the given probabilities in the table above, what is the expected EBIT for ABC Golf Equipment Corporation?

2) If the market value equals the book value of the firm’s assets, what is the current market value of ABC Golf Equipment Corporation’s assets?

3) What is the current cost of equity to the firm?

4) Based on the current share price, what is the current dividend per share?

5) Based on the current share price, what is the current dividend yield?

6) If there is no change to the stock price as a result of the share repurchase, how much equity will shareholders own after the proposed capital restructuring?

7) After the proposed change in capital structure, how much debt will the company now carry?

8) Under these market conditions, what is the firm’s optimal debt to capital ratio for the firm?

9) What is the WACC at the optimal debt to capital ratio?

10) Under a new proposed tax cut, corporate tax rates would now be reduced to 21%. Explain how the new proposed tax plan affects the optimal capital structure. What would be the optimal capital structure under the new proposed tax plan?

Answer 1

1. EBIT is given by multiplying the given probabilities with expected EBIT for that particular probability. Hence the Expected EBIT would be given by:

Probability (A)	EBIT ($) (B)	Expected EBIT (A*B) ($)
0.05	-$1 Million	-.05
0.25	2.3 Million	.575
0.40	4 Million	1.6
0.25	5.8 Million	1.45
0.05	6.1 Million	.305
Total		3.88 Million

Hence expected EBIT is $3.88 Million.

2. Current Market value of entity is given by multiplying the number of shares by Market price per share. Hence current market value is:

Number of shares*Price per share

= 500,000*27

=$13,500,000

Hence market value of assets is $13,500,000.

3. Formula for deriving current cost of equity is

Ke = Rf + (Rm - Rf)B

where

Ke = Cost of equity

Rf = Return on Risk free securities

Rm = Return on market securities

B = Beta of entity

Hence, Cost of Equity = 5% + (10%-5%)1.5

= 12.5%

4. Current Dividend per share is given by :

Dividend per share = Price per share*Return on Equity

= $27/share*12.5%

=$ 3.375 per share

5. Since whole of earning are distributed as a dividend, hence total amount distributed as dividend is:

EBIT*(1-Tax Rate)

=$3.88 Million*(1-.35)

=$2.522 Million

Therefore dividend per share is $2.522Million/ 500,000shares = $5.044 per share.

Hence dividend yield = (Dividend per share/Market price per share)*100

= ($5.044/$27)*100

= 18.68%