Question

An all-equity cash-rich company is considering the following change in capital structure:

_ borrow $50 millions at an interest rate of 6.75%

_ use the loan together with $209 millions of its own cash to repurchase 14 millions shares at the current market price of $18.50/share

Currently, the (market value) balance sheet and the income statement of the firm. are as follows (expressed in $ thousands) :

Assets	Liabilities
Cash $230,866	Debt $0
Other Assets $257,497	Equity $488,363
Total $488,363	Equity $488,363

Revenue	$346,366
Less: Cost of Goods Sold	$249,794
Gross Profit Less: Selling, General & Administrative Expenses	$96,572 $28,512
EBIT	$68,060
Earnings Before Tax Less: Taxes	$68,060 $23,821
Net Income Dividends	$44,239 $28,345

Questions:

1. Create the proforma balance sheet and income statement taking into account the proposed change in the capital structure, assuming the tax regime and payout policy (in terms of percentage of net income paid out as dividends) remain unchanged

2. Calculate the dividends per share for the current and proposed capital structure and discuss how capital structure affects the cash flows to shareholders

3. Discuss the benefits and costs of higher leverage

4. What are the costs of financial distress of the firm before the proposed share repurchase? How do you expect them to change with leverage? Why?

Answer 1

1) Income Statement

Income Statement
Revenue	$3,46,366
Less: COGS	$2,49,794
Gross profit	$96,572
Less: selling &general admin expenses	$28,512
EBIT	$68,060
Interest expense	$3,375
EBT	$64,685
Less: taxes@35%	$22,640
Net income	$42,045
Dividends	$26,939

Balance sheet

Assets	Amount	Liabilities	Amount
Cash	$21,866	Debt	$50,000
other assets	$2,57,497	Equity	$2,29,363
Total Assets	$2,79,363	Total liabilities and Equity	$2,79,363

2) Dividend per share for the current capital structure = dividends / number of shares outstanding

= 28345 / 26398

= $1.07

Dividend per share for the proposed capital structure = 26939 / 12398

= $2.17

As a result of a chnage in capital structure where the number of shares outstanding have reduced , the dividend per share increases as the payout ratio is the same. There is an increase in cash flow to the shareholders.

3) Higher leverage leads to an increase in the returns for the shareholders as the dividends per share improve. Also since interest expense is tax deductible, the overall profitabiltiy of the company increases. The overall credit rating of the compaby improves as the company pays its interests regularly.

However, higher leverage has a lot of costs as well like increased risk of failure to pay its dues on time. Also when a company is highly exposed to debt, the default risk increases which directly impacts the share price. Also the debt is costly as it has a charge attached to it as compared to equity, hence the fixed costs increases.

4) The costs of financial distress include bankruptcy costs, higher cost of capital, indirect costs, distressed asset sales and conflict of interest.

As a result of the share repurchase, the all equity capital becomes a debt equity company where the equity component is higher. As a result of the financial levergae, the company profits will increase due to interest tax shield. The share repurchase has decreased the invested capital of the company, thus leading to higher returns on capital.