Question

Taco Salad Manufacturing, Inc., plans to announce that it will issue $2.03 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 5 percent. The company is currently all-equity and worth $6.50 million with 186,000 shares of common stock outstanding. After the sale of the bonds, the company will maintain the new capital structure indefinitely. The annual pretax earnings of $1.27 million are expected to remain constant in perpetuity. The tax rate is 21 percent.

  

a.	What is the expected return on the company’s equity before the announcement of the debt issue? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
b.	What is the price per share of the company's equity? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
d.	What is the company’s stock price per share immediately after the repurchase announcement? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
e-1.	How many shares will the company repurchase as a result of the debt issue? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
e-2.	How many shares of common stock will remain after the repurchase? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
g.	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

Solution:

a. ROE = Pre-tax earnings (1 - tax rate)/Total equity

ROE = $1.27 million*(1 - 0.21)/$6.50 million

ROE = $1.0033 million/$6.50 million

ROE = 0.1544 or 15.44%

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b. Market Value Balance Sheet Before announcement

Assets Amount Liabilities Amount

Assets $6,500,000 Debt 0

Equity $6,500,000

Total $6,500,000 Total $6,500,000

Price per share = Equity/Number of shares

Price per share = $6,500,000/186,000

Price per share = $34.95

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d. Present value of tax shield = Tax rate*Value of debt

Present value of tax shield = 0.21*$2,030,000

Present value of tax shield = $426,300

Value of firm = Value of unlevered firm + Tax rate*Value of debt

Value of firm = $6,500,000 + $426,300

Value of firm = $6,926,300

Market value balance sheet after announcement of debt

Asset Amount Liabilities Amount

Old Assets $6,500,000 Debt 0

Present Value of tax shield $426,300 Equity $6,926,300

Total $6,926,300 Total $6,926,300

Price per share = Equity/Number of shares

Price per share = $6,926,300/400,000

Price per share = $17.32

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e-1. Shares repurchased = Debt issue/Price per share after debt

Shares repurchased = $2,030,000/$17.32

Shares repurchased = 117,234.31

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e-2. Number of shares left = 186,000 - 117,234.31

Number of shares left = 68,765.69

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g. Market value balance sheet after restructuring

Assets Liabilities

Old Assets $6,500,000 Debt $2,030,000

Present value of tax shield $426,300 Equity $4,896,300

(68,765.69 x $17.32)

Total $6,926,300 Total $6,926,300

Required return = ROE + Debt/Equity*(ROE - Coupon rate)*(1 - tax rate)

Required return = 15.44% + 2,030,000/4,896,300*(15.44% - 5%)*(1 - 0.21)

Required return = 15.44% + 3.42%

Require return = 18.86%