Question

Debt-free, Inc., an unlevered firm, is planning to use debt in its capital structure. The firm currently has 5,000 shares outstanding trading at $60 per share. The firm plans to sell 150 6% annual-coupon, 10-year bonds at their face values of $1,000 each and use the proceeds to repurchase some of its shares. When the bonds mature, Debt-free, Inc. plans to reissue new bonds to pay off the principal and to “roll over” its debt this way indefinitely. Assume the firm’s cost of debt does not change and there are no costs of financial distress. Earnings before interest and tax are expected to remain at $28,000 per year forever and the firm has a dividend policy of paying out all of its earnings. Maureen currently owns 100 shares of Debtfree, Inc.

(a) (i) Calculate the total dollar annual dividend Maureen receives under the firm’s existing capital structure.

(ii) If the market learns of the capital restructuring before the exercise is completed, how many shares are repurchased under the planned capital restructuring?

(iii) Calculate total dollar annual dividend Maureen receives under the firm’s planned capital structure.

(iv) Debt-free, Inc. completes its planned capital restructuring but Maureen prefers the annual dividend payout of the unlevered firm. What is Maureen’s cash flow from homemade leverage by referencing the levered firm’s capital structure and assuming that she can borrow and lend at the same rate as the firm?   

(v) Is capital structure irrelevant? Explain.

(b) Redo part (a) assuming a one-tier corporate tax rate of 20% applies. Ignore personal income taxes.  

Answer 1

(a) (i) In the old/existing capital stucture, Debt-free Inc have only Equity i.e. 5000 shares @ $60 each and no Debt.

Given,

EBIT---------$28000

Interest------$00 (No outstanding Debt)

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EBT---------$28000(EBIT-Interest)

Tax----------$5600(28000*20%)

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EAT---------$22400(EBT-Tax)

As there is no Preference Shareholder and in the given question it is mentioned that all the Earnings are distributed to Shareholder hence, Earning After Tax=$22400 are distributed to 5000 Shares.

Here, Maureen holds 100 share and his/her dividend is $ (22400/5000)*100=$448 (Anwer)

(ii) Debt-Free Inc. proposes too issue 150 bonds @ $1000 each.

So, Total Issue value of the Bond=150*1000= $1,50,000

Debt-free Inc. One Outstanding Share Value is $60.

Hence From the Bond issue value =$1,50,000, Debt-free Inc can repurchase=$1,50,000/$60= 2500 share under the planned capital restructuring. ( Answer)

(iii) In the New Planned capital stucture, Debt-free Inc have only Equity i.e. 2500 shares @ $60 each and Debt of 1500 bonds @ $1000 each having 6% interest.

Note- In the question it is mentioned that With the Bond issue value the Debt-free Inc repurchase it's share. So now share is 5000(existing)-2500(repurchase i.e. explained above)= 2500(Current)

Given,

EBIT---------$28000

Interest------$9000 (1,50,000*6%)

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EBT---------$19000(EBIT-Interest)

Tax----------$3800(19000*20%)

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EAT---------$15200(EBT-Tax)

As there is no Preference Shareholder and in the given question it is mentioned that all the Earnings are distributed to Shareholder hence, Earning After Tax=$15200 are distributed to 2500 Shares.

1. Here, Maureen holds 100 share and his/her dividend is $ (15200/2500)*100=$608 receives under the firm’s planned capital structure.(Anwer) or
2. As half of the shares are repurchase, there may be chances that Maureen shares are also repurchased. so if so then Maureen holds 50 share under planned capital structure and receives dividend= $ (15200/2500)*50=$304. (Anwer)

As question is silent that's why we represent both the situation.

(iv) Maureen's Cashflow under the 3 situation-

1. Unlevered firm- Dividend receive for 100 Share is= $448
2. Levered Firm- Dividend receive for 100 Share is= $608/$304.
3. Instead of investing money in Debt-free Inc, if he/she lend and borrow at same rate as Debt-Free Inc then earned interest is = 100*60*6%=$ 360

(v) Yes, because Debt-free Inc's Debt and Equity ratio is going to be 1:1 which is not good sign for the Company and Company also paying huge Ineterst to the Bonds holder and ultimately the shareholder decreases but Company unable to maximise the shareholder value.