Question

Green Manufacturing, Inc. plans to announce that it will issue $3 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will have a 6-percent annual coupon rate. Green is currently an all-equity firm worth $15 million, with 500,000 shares of common stock outstanding. After the sales of the bonds, Green will maintain the new capital structure indefinitely. Green currently generates annual pretax earnings of $3 million. This level of earnings is expected to remain constant in perpetuity. Green is subject to a tax rate of 40 percent.

a) What is the required return on Green’s equity before the announcement of the debt issue?

b) Construct Green’s market-value balance sheet before the announcement of the debt issue. In other words, what is the market value of the firm? What is the market value of debt? What is the market value of equity? Finally, What is the price per share of the firm’s equity?

c) Construct Green’s market-value balance sheet immediately after the announcement of the debt issue but before the issue itself. Calculate the market value of the firm, the market value of debt, and the market value of equity.

d) What is Green’s stock price per share immediately after the repurchase announcement?

e) How many shares will Green repurchase as a result of the debt issue? How many shares of common stock will remain after the repurchase?

f) Construct Green’s market-value balance sheet immediately after the restructuring. In other words, calculate the market value of the firm, the market value of debt, and the market value of equity.

g) What is the required return on Green’s equity after the restructuring?

Answer 1

a) Calculation of the expected return on equity before the announcement of the debt issue :-

Return on equity = earnings before tax ( 1 - tax rate ) / market value of equity

= 3,000,000 * ( 1- 0.40) / 15,000,000 = 0.12

expected return on equity before the announcement of the debt issue = 12%

b) Green manufacturing inc is all equity firm.

market value of equity = 15 million.

market value of equity = 0

Market value balance sheet before the announcement of debt issue.

Green manufacturing Inc.

Assets	Liabilities
Assets	15,000,000	Debt	0
		Equity	15,000,000
Total Assets	15,000,000	Total D+E	15,000,000

Price per share = market value of equity / No. of shares outstanding = 15,000,000 / 500,000

Price per share before debt issue = $ 30 per share

c) Construct Green’s market-value balance sheet immediately after the announcement of the debt issue :-

Modigliani miller proposition I states that in a world with corporate taxes:-

Vl  = Vu + Tc D

where Vl = the value of levered firm.   

Vu  = value of unlevered firm.

Tc = The corporate tax rate.

D = the value of debt in firms capital structure.

Vl = 15,000,000 + 0.40 * 3,000,000

Vl = $ 16,200,000

Market value balance sheet after the announcement of debt issue.

Green manufacturing Inc.

Assets	Liabilities
Assets	15,000,000	Debt	0
PV (Tax shield)	1,200,000	Equity	16,200,000
Total Assets	16,200,000	Total D+E	16,200,000

d) Stock price per share immediately after the repurchase announcement :-

Stock price = market value of equity after announcement of debt issue / no. of shares outstanding

= 16,200,000 / 500,000 =$ 32.4 per share

e) here market price per share after announcement will be = $ 32.4 per share.

Debt issue = $ 3,000,000

Green can repurchase = 3,000,000 / 32.4 = 92,592.59 share will be repurchase as a result of debt issue.

Green will repurchase 92,592.59 shares with proceeds from the debt issue.

Remainning shares after repurchase = 500,000 shares - 92,592.59 shares = 407,407.41 shares

f) Value of levered firm = Value of equity + value of debt

value of equity = value of levered firm - value of debt

= 16,200,000 - 3,000,000 = $ 13,200,000

Market value balance sheet after the debt issue.

Green manufacturing Inc.

Assets	Liabilities
Assets	15,000,000	Debt	3,000,000
PV (Tax shield)	1,200,000	Equity	13,200,000
Total Assets	16,200,000	Total D+E	16,200,000

g)  required return on Green’s equity after the restructuring:-

According to Modigliani-Miller Proposition II with corporate taxes

rE = rA + (D/E)(rA – rD)(1 – TC)

where rA = the required return on the equity of an unlevered firm

rE = the required return on the equity of a levered firm

rD = the pre-tax cost of debt for a levered firm

TC = the corporate tax rate

D = the market value of the firm’s debt

E = the market value of the firm’s equity

In this problem:

rA = 0.12 (see part a)

rD = 0.06

TC = 0.40

D = $3,000,000

E = $13,200,000

rE = 0.12 + (3,000,000 / 13,200,000) * (0.12 - 0.06) * ( 1 - 0.40) = 0.128182

Required return on green's levered equity after the resturcture is 12.82%