Question

Green Manufacturing, Inc., plans to announce that it will issue $2.1 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 7 percent. Green is currently an all-equity company worth $8.13 million with 500,000 shares of common stock outstanding. After the sale of the bonds, the company will maintain the new capital structure indefinitely. The company currently generates annual pretax earnings of $1.6 million. This level of earnings is expected to remain constant in perpetuity. The corporate tax rate is 30 percent.

e. What is the required return on the company’s equity after the restructuring? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Required return on Equity before repurchase = pretax earnings x (1 - tax rate) / Value of equity

or, Required return on Equity before repurchase = $1.6 million x (1 - 0.30) / $8.13 million = 0.137761 or 13.78%

Value of New equity = Value of unlevered Equity + Tax shield of debt = $8.13 million + $2.1 million x 30% = $8.76 million

Requied return post purchase will increase because now the company will have debt in the capital structure which means more risk on the earnings. More risk taken by the common stockholders' raises their expectations which means a higher required return.

Required return post repurchase can be computed using the following formula -

Required return after repurchase = Requied return before repurchase + [ (Required return before repurchase - coupon rate on debt) x (1 - tax rate) x ( Value of Debt / Value of Equity ]

or, Required return after repurchase = 13.7761% + [ (13.7761% - 7%) x (1 - 0.30) x $2.1 million / $8.76 million ]

or, Required return after repurchase = 0.14913229 or 14.91%