Question

Bellwood Corp. is comparing two different capital structures. Plan I would result in 36,000 shares of stock and $103,500 in debt. Plan II would result in 30,000 shares of stock and $310,500 in debt. The interest rate on the debt is 4 percent. Assume that EBIT will be $145,000. An all-equity plan would result in 39,000 shares of stock outstanding. Ignore taxes.

   

What is the price per share of equity under Plan I? Plan II? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

Answer 1

To find the value per share of the stock under each capitalization plan, we can calculate the price as the value of shares repurchased divided by the number of shares repurchased. The dollar value of the shares repurchased is the increase in the value of the debt used to repurchase shares, or:

Dollar value of repurchase = $310,500 - $103,500 = $207,000

The number of shares repurchased is the decrease in shares outstanding, or:

Number of shares repurchased = 36,000 - 30,000 = 6,000 shares

So, under Plan I, the value per share is:

P= $207,000 / 6,000 = $34.50 per share

And under Plan II, the number of shares repurchased from the all equity plan by the $310,500 in debt is:

Shares repurchased = 39,000 - 30,000 = 9,000

And under Plan II, the value per share is:

P= $310,500 / 9,000 = $34.50 per share

This shows that when there are no corporate taxes, the stockholder does not care about the capital structure decision of the firm. This is M&M Proposition I without taxes.