Question

A firm with a return on common equity (ROCE) of 30% has financial leverage of 37.5% and a net after-tax borrowing cost of 5% on $240 million of net debt

The firm is considering repurchasing $150 million of its stock and financing the repurchase with further borrowing at a 5% after-tax borrowing cost. What effect will this transaction have on the firm’s return on common equity if the same level of operating profitability is maintained?

Will this repurchase change the per share intrinsic value of the equity? Why?

Will the normal P/E ratio for this firm change because of this transaction? Why?

Would you expect the earnings-per-share growth rate to change after the repurchase transaction? Why?

Answer 1

1]	The return on common equity will increase, as the
	increased financial leverage from 37.5% to 60.94% will
	magnify the return to common equity, the basic earning
	pwer [operating profitability] being the same and above
	the before tax cost of debt.
	Calculation of financial leverage after restructuring:
	Total assets before restructure = $240m/37.5% =	$           640.00	m
	Financial leverage after restructuring = (240+150)/640 =	60.94%
2]	Yes, it will change the intrinsic value of equity as the
	ROCE will change and further the risk profile of the firm
	will increase due to addition of more debt.
3]	Yes, the P/E ratio of the firm will change as the risk
	of the firm will increase due to further addition of debt.
	The P/E ratio may decrease due to the increased risk.
4]	The EPS gorwth rate will also change as the ROCE will
	change. But, it will depend on the firm's retention
	policy. This is because, growth rate = ROCE*Retention
	rate.