Question

An all-equity business has 100 million shares outstanding, selling for $20 a share. Management believes that interest rates are unreasonably low and decides to execute a dividend recapitalization. It will raise $1 billion in debt and repurchase 50 million shares.

Do equity shareholders appear to have gained or lost as a result of the recap? Please explain.

Assume now that the recap increases total firm cash flows, which adds $100 million to the value of the firm. Now what is the market value of the firm? What is the market value of equity?

Answer 1

Part 1:

The buyback has both a positive and a negative impact over the equity shareholders:

• Negative in a way since they were receiving superior returns in the form of dividents. Owing to which the company decides to raise cheaper capital in the form of debt. So the shareholders who'll pledge their holding might not receive the similar return levels in the market.
• Positive impact will come by way on increasing the value of equity shares. The company is raising debt to cut down on their cost of capital. Which ultimately will increase the Enterprise Value of the company = EBIT/Cost of capital. Since the value of debt remains constant, the increase in Enterprise value will increase the market value of the equity shares.

Part 2:

Current value of company : 100 million shares * $20/share = $2 billion

After buyback of 50 million shares by raising debt:

Firm value = $1 billion equity + $1 billion debt

Increase in firm value by $100 million:

• $2.1 billion = $1 bn + Equity Value
• Equity Value = $1.1 bn