Question

Eilish Inc. plans to announce that it will issue $1.6 millin of perpetual debt and use the proceeds to
repurchase common stock. The bonds will sell at par with a coupon rate of 5%. The company is
currently all equity and worth $6.1 million with 280,000 shares of common stock outstanding. After the
sale of the bonds, the company will maintain the new capital structure indefinitely. The annual pre-
tax earnings of $1.45 million are expected to remain constant in perpetuity. Corp tax rate is 21%
What is the expected return for shareholders' of Eilish Inc. as an unlevered firm?
What is the price per share of the firm's equity currently?
What is the price per share of the firm's equity immediadiately after the announcement of the debt issue?
What is the required rate of return in the company's equity after the restructure?

Answer 1

Given

Annual pre tax Earnings = $ 1450000

Tax rate = 21%

a)Computation of Expected return of a unevered firm.

Post tax earnings= Pre tax earnings ( 1-Tax rate)

= $ 1450000( 1-0.21)

= $ 1450000*0.79

= $ 1145500

Expected return on Equity = Earnings after Tax / Market value of Equity*100

= ($ 1145500/$ 6100000)*100

= 18.78%

Hence Expected return for shareholders is 18.78%

b)Computation of Current price per share.

Current Market price per share = Market value of a firm / No.of shares

= $ 6100000/280000

= 21.7857

Hence the Current market price per share is 21.7857

c)Computation of Market price per share after the debt announcement.

Market value of the firm will be increased by tax shield on the Debt amount.

Market value of the firn ( After announcement ) = Existing market value + Debt * Tax rate

= $ 6100000+ $ 1600000*0.21

= $ 6100000+$ 336000

= $ 6436000

Market price per share after announcement = Market value of firm / No.of shares

= $ 6436000/280000

= $ 22.9857

Hence Market price price after announcemet is 22.9857

d)Computation of Required rate of return after restructure

We know that Cost of Levered firm = Cost of unlevered firm + Debt / Equity *( Cost of Equity in unlevered firm - Cost of Debt) ( 1-Tax rate)

= 0.1878+ $ 1600000/$ 4836000( 0.1878-0.05)( 1-0.21)

= 0.1878+ 0.330852( 0.1378)( 0.79)

= 0.1878+0.036017

= 0.223817

Hence required rate of return after Capital restructure is 22.3817%

* Market value of firm = Market value of Equity + Market value of Debt

$ 6436000= Market value of Equity +$ 1600000

$ 6436000-$ 1600000= Market value of Equity

$ 4836000= Market value of Equity