Question

Sam Adam’s Brewery Inc. currently has USD 200m 20in market value of common stock outstanding priced at $20 per share. Sam Adam’s also
has USD 50m in 20 year bonds carrying a 10% coupon. The firm is considering a capital restructuring proposal that consists in issuing new debt for USD 50m and repurchasing an equivalent amount of stock. The interest on the new debt will also be 10%. Earnings before interest and taxes (EBIT) for the firm is USD 35m.

1. (a) If there are no taxes, what will be the effect of the proposed restructuring on earnings per share (EPS), required return on equity and the value of the firm’s stock?

2. (b) If the firm now pays 34% in taxes, is this restructuring advantageous to Sam Adam’s Brewery? Support your position quantitatively.

3. (c) The Modigliani and Miller proposition under corporate taxes finds the optimal debt ratio to be very close to 100%. In their world, debt-for-equity restructurings (raise debt to retire equity) is always advantageous. From your perspective, do you believe that this is always true? Identify the tradeoffs a firm must make in determining whether or not to engage in this type of restructuring.

Answer 1

a). Stock value = US$200 million

Price per share = US$ 20

No.of shares = US$200/US$20

= 10 million shares

Company has Bond = US$ 50 million , duration = 20years, Copoun rate=10%

Copoun amount = 50*10%

= US$ 5 million

Calculation of Earning per share:

EBIT US$ 35 m

Less: Interest US$ 5 m

PAT US$ 30m

EPS = PAT/Number of shares

= US$ 30 m/10m

= US$ 3.00

Now, the company plans to issue new Debts of US$ 50m @ 10% interest rate

The company also plans to repurchase equal stocks

Number of stocks repurchase = US$ 50m/US$20

= 2.50m shares

So,the present number of shares = 10m-2.5m

= 7.5m shares

Expected EPS = US$(30 - 50*10%)m

= US$ 25m

Therefore, EPS = US$25m/7.50m

= US$ 3.33

Impact on EPS : Increase by US$ 3.33- US$ 3.00 = US$0.3

Calculation for impact on ROE:

Current ROE = PAT/Networth *100

= US$ 30m/ US$ 200 m *100

= 15%

Expected Net worth after repurchase = 7.5 m shares * US$ 20

= US$ 150m

Expected ROE = US$ 25m / US$ 150m * 100

= 16.67%

Therefore ROE increased by 16.67% -15% =1.67%

Current Stock of the company = US$ 200m

Expected stock of the company= US$ 150m

Value of stock decreases by US$ 50m

b)The company now pays tax@34%

EBIT US$ 35 m

Less: Interest US$ 10 m

US$ 25 m

Less: tax@34% US$ 8.5 m

PAT US$ 16.5m

EPS = US$ 16.5m/ 7.5m

= US$ 2.20

So there is a reduction of EPS by US$(3.33 - 2.20)m = US$ 1.13m

ROE = US$ 16.5m/ 7.5m *100

= 11%

There is a decrease in ROE as well.

So.it is not advantageous for the company to pay tax @34%.

c)No.the debt to equity restructuring id not always advantegeous for the company.

Debt for equity sometimes beneficial for the companies especially large companies when they are

incurring huge lossess for more than couple of years.Consequentially those loss making firms are taken over

or purchase by their credtors.

Tradeoffs: The firm must not issue more debts as it involves payment of interest which eventually reduces EPS and

ROE.