Question

Assume you have just been hired as a Finance Manager of Anjung Puteri. The company’s earnings before interest and taxes (EBIT) was RM500,000 last year and is expected to remain constant over time. Since no expansion capital will be required, Anjung Puteri plans to pay out all earnings as dividends. The management group owns fifty percent (50%) of the stock and the rest is traded in the over-the-counter market. In your finance course, you learned that most firm owners would be financially better off if the firm used some debt. When you suggested this to your new boss, she encouraged you to pursue the idea. Anjung Puteri is currently financed with all equity, it has 100,000 shares outstanding and the current market price is RM15 per share. If Anjung Puteri were to recapitalize, debt would be used, and the funds received would be used to repurchase stock at the RM15 per share market price. Anjung Puteri is in a 24% tax bracket. The company leases all its equipment and its building. Therefore, Anjung Puteri has no depreciation expense. From your finance training, you know that there is an optimum relationship between debt and equity at which the market value per share will be maximized. You recall that you can use estimated cash flows, weighted average cost of capital (WACC), and the capital asset pricing model (CAPM) to estimate share value. As a first step you found the following information on Yahoo finance: “The current prime borrowing rate is 5.14% and the current risk-free rate (10 year Malaysia Government bond) is 3.07%. You estimate the market risk premium into the foreseeable future at 8%. Next, you obtained from a local investment banker the following estimated debt risk premiums and subjective betas for Anjung Puteri at various debt levels:

Scenario	Amount Borrowed (RM)	Debt Risk Premium (%)	Subjective Beta
1	0	2.0	2.0
2	187,500	2.0	2.1
3	375,000	2.5	2.3
4	562,500	3.5	2.5
5	750,000	5.0	2.9
6	937,500	7.0	3.3
7	1,125,000	10.0	3.7

Required:

1. What will be the amount of equity after repurchasing of stock under each debt scenario?             
2. What will be the weights of debt and equity under each debt scenario?
3. What will be the after-tax cost of debt under each debt scenario?
4. What will be the cost of equity (CAPM) under each debt scenario?
5. What will be the weighted average cost of capital (WACC) under each debt scenario?
6. How many shares will be repurchased and how many will remain outstanding under each debt scenario?
7. What is the estimated total asset value and total equity value under each debt scenario?

Hint: Total Asset = Earning/WACC

8. What is the estimated market value per share under each debt scenario?
9. It is also useful to determine the effect of recapitalization on earnings per share. Calculate the EPS under each debt scenario.
10. Briefly explain the trade-offs between debt and equity financing.

Answer 1

a. What will be the amount of equity after repurchasing of stock under each debt scenario?

Current Equity shares = 100,000 shares

Scenario	Debt	No of shares repurchased @ RM 15 per share	No of Equity after repurchase	Amount of equity after repurchasing @ RM 15 per share
I	0	0	100000	15,00,000.00
II	187500	12500	87500	13,12,500.00
III	375000	25000	75000	11,25,000.00
IV	562500	37500	62500	9,37,500.00
V	750000	50000	50000	7,50,000.00
VI	937500	62500	37500	5,62,500.00
VII	1125000	75000	25000	3,75,000.00

b. What will be the weights of debt and equity under each debt scenario?

Scenario	I	II	III	IV	V	VI	VII
In Amount
Debt	0	187500	375000	562500	750000	937500	1125000
Equity	1500000	1312500	1125000	937500	750000	562500	375000
Total	1500000	1500000	1500000	1500000	1500000	1500000	1500000
In Weights
Debt	0.000	0.125	0.250	0.375	0.500	0.625	0.750
Equity	1.000	0.875	0.750	0.625	0.500	0.375	0.250
Total	1.000	1.000	1.000	1.000	1.000	1.000	1.000

c. What will be the after-tax cost of debt under each debt scenario?

Prime lending rate	5.14%
Applicable Tax rate	24%

Scenario	Debt Risk Premium	Applicable borrowing rate (Pre-Tax)	Post tax borrowing rate
I	2	10.28%	7.81%
II	2	10.28%	7.81%
III	2.5	12.85%	9.77%
IV	3.5	17.99%	13.67%
V	5	25.70%	19.53%
VI	7	35.98%	27.34%
VII	10	51.40%	39.06%

d. What will be the cost of equity (CAPM) under each debt scenario?

Ke

=

Rf + Beta (Risk Premium)

Rf	3.07%
Market Risk premium	8%

Scenario	Beta	Cost of Equity
I	2	19.07%
II	2.1	19.87%
III	2.3	21.47%
IV	2.5	23.07%
V	2.9	26.27%
VI	3.3	29.47%
VII	3.7	32.67%

e. What will be the weighted average cost of capital (WACC) under each debt scenario?

Scenario	I	II	III	IV	V	VI	VII
Weight
Debt	0.000	0.125	0.250	0.375	0.500	0.625	0.750
Equity	1.000	0.875	0.750	0.625	0.500	0.375	0.250
Cost of:
Debt (Post tax)	7.81%	7.81%	9.77%	13.67%	19.53%	27.34%	39.06%
Equity	19.07%	19.87%	21.47%	23.07%	26.27%	29.47%	32.67%
WACC	19.07%	18.36%	18.54%	19.55%	22.90%	28.14%	37.47%

f. How many shares will be repurchased and how many will remain outstanding under each debt scenario?

S.No	Debt scenarios	No of shares repurchased @ RM 15 per share	No of Equity after repurchase
I	-	-	1,00,000
II	1,87,500	12,500	87,500
III	3,75,000	25,000	75,000
IV	5,62,500	37,500	62,500
V	7,50,000	50,000	50,000
VI	9,37,500	62,500	37,500
VII	11,25,000	75,000	25,000

g. What is the estimated total asset value and total equity value under each debt scenario?

Scenario	I	II	III	IV	V	VI	VII
EBIT	500000	500000	500000	500000	500000	500000	500000
EBIT(1-t)	380000	380000	380000	380000	380000	380000	380000
WACC	19.07%	18.36%	18.54%	19.55%	22.90%	28.14%	37.47%
Value of Asset	1992658.63	2069395.55	2049180.33	1944141.74	1659316.19	1350306.93	1014266.46
Debt	0	187500	375000	562500	750000	937500	1125000
Value of Equity (Market Value)	19,92,658.63	18,81,895.55	16,74,180.33	13,81,641.74	9,09,316.19	4,12,806.93	-1,10,733.54
No of shares	100000	87500	75000	62500	50000	37500	25000
a) Value per share	19.927	21.507	22.322	22.106	18.186	11.008	-4.429
b) EPS Calculation
EBIT	500000	500000	500000	500000	500000	500000	500000
Less:Interest	0	19275	48187.5	101193.75	192750	337312.5	578250
PBT	500000	480725	451812.5	398806.25	307250	162687.5	-78250
Less: Tax @ 24%	380000	365351	343377.5	303092.75	233510	123642.5	0
PAT/ Earnings available to ESH	120000	115374	108435	95713.5	73740	39045	-78250
No of shares	100000	87500	75000	62500	50000	37500	25000
EPS	1.2	1.31856	1.4458	1.531416	1.4748	1.0412	-3.13