Question

DIY has EBIT of $4 million per year forever. Its cost of equity is 12% and tax rate is 40%. There are 1.2 million shares outstanding. It also has $8 million (face value) perpetual debt which pays annual coupon of 5%, and is trading at 125% of the face value. DIY wants to borrow new perpetual debt of $2 million at current cost of debt to buy back its common stocks. Due to this new debt, there will be present value of bankruptcy cost of $300,000.

2.Calculate the equity value, firm value, stock price, debt equity ratio, and EPS under the new capital structure.

Answer 1

  Earning for shareholder=EBIT- Interest on debt - tax rate(EBIT-Interest on debt)

  Earning for shareholder =4 million-0.5million(10million*5%)-0.40(4million-0.50million)

Earning for shareholder = 2.10million

No. of shares left after buy back=0.31 million  ( REFER TO WORKING NOTE)

EPS=Earning for shareholder / no. of shares left after buy back

=2.10million/0.31million

=0.651million

Debt Equity Ratio=Total debt/equity after buy back = 8million+2million/ 0.31million =32.26

Equity Value=total shares left*current market price=0.31*2.25

Firm Value= total value of debt+ total value of equity=10+0.6975=10.6975

WORKING NOTE ; CALCULATION OF NO. OF EQUITY SHARES THAT CAN BE BUY BACKED

BEFORE INTRO OF NEW CAPITAL STRUCTURE

Earning for shareholder=EBIT- Interest on debt - tax rate(EBIT-Interest on debt)

=4million-0.4(8miilion*5%)-40%(4miilion-0.4million)

= 2.16million

no.of shares= 1.2million

EPS=1.8

MPS=1.8*125%=2.25

NO. of shares that can be buy backed by using 02million debt =2million/2.25

=0.89million

no.of shares left after buy back= 1.2million-0.89million