Question

Trident Corporation is currently worth $16 million. Its current debt-to-value (D/V) ratio is 60%. The company is confident in meeting its debt obligation, and wants to introduce more debt to take advantage of the tax shield of interest payment. It is planning to repurchase part of the common stock by issuing more corporate debt. As a result, the firms debt value is expected to rise by $1.4 million. The cost of debt is 8 percent per year. Trident expects to have an EBIT of $2.4 million per year in perpetuity. Tridents tax rate is 30%.

(a) What would be the market value of Trident Corporation if it were unlevered? What would be the expected return on equity if Trident were an all-equity firm?

(b) What is the expected return on the firms equity before the announcement of the stock repurchase plan?

(c) What is the value of equity after the announcement of the stock repurchase plan? How much money do the equityholders expect to receive each year under the new capital structure? What is the expected return on the firms equity after the announcement?

(d) How much does the value of the firm increase after the announcement? If the goal is to maximize the firms value, would you recommend the CEO of Trident to borrow as much as they can? Please explain your rationale. Ignore the cost of financial distress and agency cost.

(e) Now we consider the downside of debt borrowing: cost of financial distress and agency cost. The more debt there is, the more costly it could be when the firm fails to meet its debt obligation. Suppose the firm expects to incur an additional cost of $360,000 for this $1.4 million increase in leverage. If the goal is to maximize the firms value, would you recommend the CEO of Trident to proceed with this repurchase plan? Please explain your rationale.

Answer 1

Part a)

• Enterprise value = $16 million
• EBIT = $2.4 million

WACC = (EBIT / EV) * 100 = 15%

WACC = Cost of debt 8% * (1-Tax 30%) * D/V 60% + Cost of equity * E/V 40% (1-D/V%)

Cost of equity = {WACC 15% - Cost of debt 5.6% }/40%

Cost of equity = 29.1%

Value of un-levered firm = EBIT $2.4 million / Cost of equity 29.1%

Value of un-levered firm = $8.25 million

Return on equity = EBIT $2.4 million * (1- Tax 30%) / Value of un-levered firm $8.25 million

Return on equity = 20.37%

Part b)

Current equity value = $16 million * E/V 40% = $6.4 million

Current debt value = $16 million * D/V 60% = $9.6 million

Interest rate = 8%

Interest payments = $9.6 million * 8% = $0.768 million

EBT = EBIT $2.4 million - Interest $0.768 million = 1.632 million

NOPAT = EBT 1.632 million * (1 - Tax 30%) = $1.1424 million

Return on equity = NOPAT $1.1424 million / Current equity value $6.4 million = 17.85%

Part c)

New Debt Value = $9.6 million + $1.4million = $11 million

New Value of Equity = $5 million

New WACC = Cost of debt 8% * (1-Tax 30%) * D/V 68.75% + Cost of equity 29.1% * E/V 31.25%

New WACC = 12.94%

New enterprise value = EBIT $2.4 million / New WACC 12.94% = $18.54 million

Value of equity after announcement = New enterprise value $18.54 million - New Debt Value $11 million

Value of equity after announcement = $7.54 million

New interest payments = New debt value $11 million * 8% = $0.88 million

NOPAT = { EBIT $2.4 million - Interest $0.88 million } * (1-Tax rate 30%) = $1.064 million

Expected earnings of equity shareholders = $1.064 million

Return on equity = NOPAT $1.064 million / New equity value $7.54 million = 14.11%

Part d)

Firm value increases to $18.54 million from $16 million.

No we shouldn't advise the CEO to increase money via debt as much as they can since the debt will increase the interest burden on the firm which will increase the financial leverage which will lead to increase in cost of borrowing.

The debt should be included in the capital structure till the time they're adding value to the firm. The moment additional debt started reducing the value to the firm company should stop raining money via this mode.

Part e)

New enterprise value of firm = $18.54 million

Distress cost = $0.36 million

Adjusted enterprise value =  $18.54 million - $0.36 million = $18.18 million which is also greater than the current enterprise value. Hence the company should still go ahead with raising debt.