Question

Syntonic Limited is an Australian-based company subject to the classical tax system, with a corporate tax rate of 30%. Historically, the company has been successful with its projects and currently generating earnings before interest and taxes (EBIT) of $8 million per year, and this level of earnings is assumed to continue forever. However, due to increased competition in its markets, many of its customers are shifting to new service providers. All of the company’s finance has come from shares issued at a cost of 18%. Due to a boardroom dispute, the company is proposing to buy back shares from a group of dissatisfied shareholders by borrowing $28 million at an interest rate of 15%. (i) What is the value of the company with an all-equity capital structure? [3 points] (ii) According to Modigliani and Miller (MM) approach with corporate taxes, what is the value of the company if it borrows the money and uses it to repurchase shares? [3 points] (iii) Explain the financial distress risk of Syntonic Limited after it had borrowed the money to buy back its shares? [9 points] (provide both workings and answers in the answer box)

Answer 1

Syntonic Limited
Valuation
Ans i	Amt $
EBIT =	8,000,000
Less Tax @30%	2,400,000
Net Income After Tax	5,600,000
Cost of Equity =	18%
As the company is all equity funded,
Value of company= PAT/Cost of Equity=$5.6M/18%=	$     31,111,111	Ans i
Ans ii
As per MM hypothesis, Value of a Geared entity=
Value of Ungeared entity +Debt*Tax rate
Value of debt =$28M
Tax rate =30%
Value of the company=31,111,111+28,000,000*0.30
=39,511,111
So value of the company with debt =	$      39,511,111	Ansii

Ans iii.
The financial distress risk of Syntonic Ltd after it borrows the
money and uses it to repurchase shares will generate from the
additional burden of fixed finance charges of $4.2 M interest
expense and the principal repayment as per loan schedule.
As there is issue with customer retention , the revneu in
under threat. The debt has not generated any additional
asset or sales generating potential , there is a risk that the future
sales and net income will come down. If future the income is not
sufficient to service the financial obligations of the debt, then there
is high risk of financial stress in future years.