Question

In: Accounting

(A) A company has a capital structure comprising 5 million issued shares with a current market...

(A) A company has a capital structure comprising 5 million issued shares with a current market price of $10 per share. Expected profit is $6 million, all of which will be paid out as dividends. The company has no debt and pays no tax on its profits.

(i) Under the present capital structure, what is the market value of the firm?

(1 mark)

(ii) What is the rate of return (% pa) on the company’s equity capital?

(1 mark)

(iii) Suppose the company issues $5 million of long-term debt at an interest rate of 8% and uses the entire proceeds of the issue to buy back some of its ordinary shares.

(a) What will be the annual interest bill (in dollars)?

(b) What will be the expected annual profit after paying interest?

(c) How many shares will be bought back?

(d) What will be the total market value of equity after the share buy-back?

(e) What will be the total market value of the company (equity plus debt) after the share buy-back?

(f) What will be the rate of return (% pa) on the company’s equity capital after the share buy-back?

(g) What will the company’s weighted average cost of capital (WACC) after the share buy-back? [Note that WACC is the rate of return (% pa) on the company’s total capital (equity plus debt).]

Expert Solution

A)

i) Market Value of the firm = MPS*No. Of shares

=$10*5 million = $50 million

ii)Rate of return on equity = Earnings for Equity/Equity Share Capital

=6 million/50 million * 100 =

12%

iii)a)Annual Interest Bill = $5million*8% = $0.4 million

b)Expected annual Profit after paying interest = $6million-$0.4million = $5.6 million

c)Market Value per Share = $10

Amount received by issuing debt = $5million

No. Of shares bought back = 5million/10 = 0.5 million

d) The total market value of equity after the share buy-back = 4.5million*10

=$45 million

e) The total market value of the company (equity plus debt) after the share buy-back

= Value of Equity + Value of Debt

=$45 million + $5 million = $50 million

f) The rate of return (% pa) on the company’s equity capital after the share buy-back

= Earnings for Equity/Equity Capital

= 5.6 million/45 million * 100 = 12.44%

g)WACC after buy back = ke*we+kd*wd

=12.44*45/50 + 8*5/50

=12%

ekkarill92 answered 1 year ago

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