Question

You are trying to evaluate the effects of issuing 300 million of new debt and using the proceeds either to pay a dividend or to repurchase shares for Star Inc. Star Inc. currently has 232.44 million shares outstanding and is trading at $56.37 per share. Its current book value of equity is 127.6 million and EBIT is 527 million. Tax rate is 40%. Cost of debt for the new debt is 13%.

a.) Star's book value and market value of equity after debt issuance.

b.) What will be the number of shares outstanding and the new share prices? please show for both the dividend and repurchase scenario.

c.) What will happen to the earnings per share. Please show for both the dividend and repurchase scenario.

Answer 1

a) First we will calculate the book value and market value of the Equity before and after the debt issuance.

Book Value of equity before debt issuance:

127.6 million/232.44 million = 0.5489 per share

Market value of equity before the debt issuance: 232.44 million * 56.37

= 13.102 billion

if the firm raises 300 million debt to distribute it as dividends the dividend per share will be

300 million/232.44 million = 1.29 is the dividend per share

The stock price will be reduced by the amount of the dividend distributed.

So the new stock price will be 56.37 - 1.29 = 55.08 will be the price of the share after the distribution of the dividend. So the market value of the equity will be 55.08 * 232.44 = 12.802 billion.

If the firm uses the amount raised to buy back the share if will be able to purchase

300,000,000 / 56.37 = 5,321,979.77 shares

So the market value of the equity will be 13102 million - 300 million - 12,802 billion.

Book Value of shares outstanding will be 227,118,020.2 * 0.5489 = 124,665,081.3 million.

Also note that the market value of share either through dividend distribution or through share repurchase will be the same.

b) The no of shares outstanding will be 227,118,020.2 (232,440,000 - 5,321,979.77)  

As calculated above the share price per share after dividend distribution will be 55.08 and the share price after share repurchase will be 56.37. But the equity value will be the same.

c) Earnings per share calculation: first we will calculate the earnings per share when the debt is distributed as dividends

Particulars	Amount
EBIT	527000000
minus interest @ 40%	39000000	interest is 13% of 300 million
EBT	488000000
minus TAX	195200000	taxes are @ 40%
PAT	292800000
No of shares outstanding	232440000
Earnings per share	1.260

No we will calculate the earnings per share after the buyback of shares

As we have calculated the new no of shares outstanding after the buy back we have the following eps

Particulars	Amount
EBIT	527000000
minus interest @ 40%	39000000	interest is 13% of 300 million
EBT	488000000
minus TAX	195200000	taxes are @ 40%
PAT	292800000
No of shares outstanding	22,71,18,020.20
Earnings per share	1.289

As we see the EPS has increased because the no of shares are reduced from the market.