Question

GameY Inc.has 30 million shares outstanding, with current market price at $2.50 and the company is entirely equity financed. The company plans to purchase a new factory at $10 million and an additional $5 million would be needed to renovate the factory. This purchase is expected to increase the company’s annual pretax earnings by $4 million in perpetuity. The company’s current cost of capital is 10 percent. The company is deciding which capital structure to be used. Based on some discussions with investment banks, the company can issue bonds at par value with a coupon rate at 6 percent. The company feels that capital structure in the range of 70 percent equity/30 percent debt would be optimal. The company has a 21% corporate tax rate.

a) Suppose The GameY Inc. decides to issue equity to finance the project, what is the price per share of the firm’s stock?

b) Suppose The GameY Inc. decides to issue debt to finance the project, what is the price per share of the firm’s stock?

c) Which is better? Debt financing or equity financing?

excell plz

Answer 1

Information:-
Currently market price/share	$ 2.50
Shares Outstanding	30 Million
No Debt currently
So market value of firm	$ 75 million
Current cos of capital	10% which can say equal to cost of equity
Assumption:-
We assume cost of equity doesn't changed in leverged firm, because we haven't any information about beta

Answer to Part (a)
Assume issue priceof share $ 2.50
Project finance	$ 15 million
Shares new issue	6 million
Perpectual Earnings	$       4.00
Less:- Tax @ 21%	$       0.84
Cash Earnings	$      3.16	million
PV of earnings	$    31.60	million
Market value after issue	= 75 + 31.60 + 15
	$ 121.60	million
Shares outstanding	36	million
Price / share after issue	$      3.38

Answer to Part (b)
Debt value, 6%	$    15.00	million
Perpectual Earnings	$       4.00
Less:- Interest expense	$       0.90
EBT	$      3.10
Less:- Tax @ 21%	$       0.65
Cash Earnings	$      3.35	million
Cost of capital	= 10% * 0.7 + 6% * 0.3 * (1-0.21)
	8.42%
PV of earnings	$    39.77	million
Market value after issue	= 75 +39.77+15-15
	$ 114.77	million
Shares outstanding	30	million
Price / share after issue	$      3.83

(c) Option (b) is better.