Question

Newkirk, Inc., is an unlevered firm with expected annual earnings before taxes of $22.4 million in perpetuity. The current required return on the firm’s equity is 20 percent, and the firm distributes all of its earnings as dividends at the end of each year. The company has 1.44 million shares of common stock outstanding and is subject to a corporate tax rate of 35 percent. The firm is planning a recapitalization under which it will issue $31.4 million of perpetual 10.4 percent debt and use the proceeds to buy back shares. a-1. Calculate the value of the company before the recapitalization plan is announced. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.) Current value $ a-2. What is the price per share? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Price per share $ b-1. Use the APV method to calculate the company value after the recapitalization plan is announced. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.) Value after recapitalization $ b-2. What is the price per share after the recapitalization is announced? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Price per share $ c-1. How many shares will be repurchased? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.) Shares repurchased c-2. What is the price per share after the recapitalization and repurchase? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Price per share $ d. Use the flow to equity method to calculate the value of the company’s equity after the recapitalization. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.) Value of the equity $

Answer 1

EBIT = $ 22.4 million, Tax Rate = t = 35 % , Required Return on Equity = Cost of Equity = k(e) = 20 % and Number of Shares Outstanding = N = 1.44 million.

NOPAT (net operating profit after taxes) = 22.4 x (1 - 0.35) = $ 14.56 million

As there is no information provided about Capital Expenditure, changes in Net Working Capital and Depreciation/Amortization expenses, all of the same are assumed to be zero.

Therefore, Free Cash Flow to Firm = FCFF = NOPAT - Capital Expenditure + Depreciation - Changes in NWC

FCFF = 14.56 - 0 + 0 - 0 = $ 14.56 million

(a1) Company Value before Recapitalization = V(I) = FCFF / k(e) = 14.56 / 0.2 = $ 72.8 million

(a2) Price per Share = V(I) / N = 72.8 / 1.44 = $ $ 50.555

(b1) Once, the company announces equity recapitalization by means of raising debt, the firm value should increase immediately so as to reflect the value addition generated by the newly included debt's interest tax shield. Such an occurence would require us to assume that security markets price securities efficiently. This essentially implies that the share price (on account of firm value increment due to the tax shield value addition) should increase immediately post the recapitalization announcement and not on the actual day of the debt for equity swap.

Therefore, the firm value post-recapitalization announcement = Value of Firm's Existing Asset (calculated in a1) + Value Added by PV of Interest Tax Shield = 72.8 + (31.4 x 0.35 x 0.104) / 0.104 = 72.8 + 10.99 = $ 83.79 million

(b2) Value per share post announcement = New Firm Value (including interest tax shield value) / N = 83.79 / 1.44 = $ 58.1875

The number of shares outstanding is still 1.44 million as only the recapitalization announcement has been made, the actual act of recapitalization has not been carried out yet.

NOTE: Please raise separate queries for solutions to the remaining sub parts.