Question

Paul Rosenzweig is founder and CEO of? OpenStart, an innovative software company. The company is? all-equity financed, with100 million shares outstanding. The shares are trading at a price of $1.Rosenzweig currently owns 10 million shares. There are two possible states in one year. Either the new version of their software is a?hit, and the company will be worth $150?million, or it will be a? disappointment, in which case the value of the company will drop to $75 million. The current risk free rate is 4.3%.

Rosenzweig is considering taking the company private by repurchasing the rest of the outstanding equity by issuing debt due in one year. Assume the debt is?zero-coupon and will pay its face value in one year.

a. What is the market value of the new debt that must be? issued?

b. Suppose OpenStart had? risk-free debt with a face value of $75 million. What would be the value of its debt and levered equity? today?

c. What fraction of the levered equity in ?(b?) would you need to combine with the? risk-free debt in ?(b?) to raise the amount in left parenthesis Bold a right parenthesis(a)??

d. What are the payoffs of the portfolio in ?(c?)?

What face value of risky debt would have the same? payoffs?

e. What is the yield on the new debt that will be required to take the company? private?

f. If the two outcomes are equally? likely, what is? OpenStart's current WACC? (before the? transaction)???

g. What is? OpenStart's debt and equity cost of capital after the? transaction? Show that the WACC is unchanged by the new leverage.

Answer 1

Formula sheet

A	B	C	D	E	F	G	H	I
2
3		Number of shares outsatinding	100	million
4		Current Share Price	1
5		Number of shares owned by CEO	10	million
6
7		a)
8
9		Since amount of debt is to buy all the remaining shares in the market,
10		therefore market value of debt should be equal to the market value of equity to be purchased.
11
12		Number of share to be purchased	=D3-D5	million
13		Price per share	1
14		Total market Value of equity to be purchased	=D12*D13	million
15
16		Market Value of debt to issued	=Market value of equity to be purchased
17			=D14	million
18
19		Hence Market Value of debt to issued	=D17	million
20
21		b)
22
23		Face Value of risk free zero coupon debt	75	million
24		Risk free rate	0.043
25		Maturity	1	Year
26
27		Market Value of Debt	=Present Value of the Face Value
28			=$75*(P/F,4.3%,1)
29			=D23*(1/((1+D24)^D25))	=D23*(1/((1+D24)^D25))
30
31		Hence market value of debt	=D29	million
32
33		c)
34
35		Market Value of debt	=D31	million
36
37		Equity before issue of debt	=D3*D4	million
38		Amount of equity bought by issuing debt	=D35	million
39		Equity after issue of debt	=D37-D38	million
40
41		Therefore the final capital structure will be
42		Debt	=D35	million
43		Equity	=D39	million
44		Market Value of Firm	=SUM(D42:D43)	million
45
46		Fraction of Debt	=D42/D44	=D42/D44
47		Fraction of Equity	=D43/D44	=D43/D44
48
49		d)
50
51		Value of firm in year1 will be as follows:
52
53		State	Payoff in Year 1
54		New Version is Hit	150	million
55		New Version Disappointment	75	million
56
57		Debt will be paid first out of the worth of the company and then the remaining amount will be payoff of equity.
58
59		Payoff for Debt will be as follows:
60
61		State	Payoff in Year 1
62		New Version is Hit	75	million
63		New Version Disappointment	75	million
64
65		Payoff for Equity will be as follows:
66
67		State	Payoff in Year 1
68		New Version is Hit	=D54-D62	million
69		New Version Disappointment	=D55-D63	million
70
71		Face value of less than 75 million for debt will have same payoff in both state.
72