Question

Vernon Dursley, recently promoted to the position of CFO at Grunnings, the internationally renowned supplier of drills based in Lit-
tle Whinging, Surrey, England, faces irresistible pressure from institutional shareholders to
improve the firm’s languishing stock performance. Despite considerable cash reserves at this conservatively managed firm, the stock price has slipped from GBP 6.80 to GBP 3.00 per

share for a total market capitalization of GBP 300m on the London Stock Exchange.1 The firm has also a GBP 100m bond issue outstanding that carries an 8% coupon, has 15 years maturity left, and is currently trading at par.

While personally opposed to shareholder activism, Vernon Dursley has little choice but to heed the demands of Grunnings’ largest shareholder, the International Witchcraft Professionals Retirement Fund (officially IWPRF but in the industry simply known as the “Witches and Wizards”), to issue GBP 90m in additional 15 year debt and repurchase an equivalent amount of stock. (Cash) earnings before interest and taxes (cEBIT) for Grunnings are currently running at GBP 80m and are projected to grow at about 2% per annum indefinitely.

Assume that current cash reserves are sufficient to cover any immediate debt service obliga- tions by Grunnings. Also, unless otherwise stated, ignore bankruptcy, taxes and transaction costs in your analysis and assume that payout choices do not affect the drill maker’s invest- ment, financing and operating policies.

(a) Calculate Grunnings’ earnings per share (EPS), required return on equity (ROE), and the market value of equity before and after the proposed restructuring. Which capital structure offers the riskier investment? Explain the difference.

	Old Capital Structure	New Capital Structure
EPS
ROE
MVE

(b) The preceding is an application of which celebrated result? Which of its underlying assumptions are most likely to be violated in practice?

(c) Consider the incidence of British corporate taxes at 40%. Is the financial restructuring still beneficial to the company and, if so, why?

(d) Diagon Magical Mutual Foundation (made famous by their “Every coin has two sides” investment motto and synonymous advertising campaign), another important share- holder owning 10m shares in Grunnings, wishes to maintain its current 10% stake in the company after the restructuring. What should its trustees do? Propose an investment strategy that keeps the foundation’s stake constant and calculate their return before and after the recapitalization.

(e) A direct consequence of the celebrated corporate-finance insights discussed above is the idea that investors can adjust the leverage of any firm on their own through their portfolio choices. Two prominent investment strategies closely correspond to the respective adjustments. What are they and what are their respective drawbacks? Ex- plain.

Answer 1

a)

Old Capital Structure:

Earnings per share (EPS): Net Income / No. of Shares outstanding

(Not considering taxes as it is given separately for option C)

Np. of shares outstanding = Market Capitalisation / Current Stock Price

= 300m / 3

=100m.

Therefore, Earnings/share (EPS) = 80m / 100m = 0.8

Return on Equity (ROE): Net Income / Total Equity

=80m / 300m = 0.267

MVE = 300m (Given)

New Capital Structure:

Additional 90m are issued under debt and used to repurchase equivalent amount of stock.

No. of shares repurchased = Amount used for repurchasing / Current Stock Price

= 90m / 3 = 30m.

Therefore, total no. of shares under new capital structure: 100m - 30m = 70m

Therefore, Earnings/share (EPS) = 80m / 70m = 1.14

Return on Equity (ROE) = 80m / 300m = 0.267

MVE = 300m (Given)

	Old Structure	New Structure
EPS	0.8	1.14
ROE	0.267	0.267
MVE	300m	300m

b)

The example given above is related to share buyback.

One of the most common consequences of share buyback is increase in the stock price. In this example, share buyback is done to increase stock price and EPS.

However, there is increase in EPS due to decrease in no. of outstanding shares. As you can clearly see the table above, under the new structure, there is increase in EPS but ROE and MVE are same.