Question

Use the following information to complete the quiz:
The All-Star Production Corporation (APC) is considering a recapitalization plan that would convert APC from its current all-equity capital structure to one including some financial leverage. APC now has 10,000,000 shares of common stock outstanding, which are selling for $40.00 each, and you expect the firm’s EBIT to be $50,000,000 per year for the foreseeable future.

APC shareholders require a 12.5 percent return on their investment in APC.

The recapitalization proposal is to issue $100,000,000 worth of long-term debt at an interest rate of 6.50 percent and use the proceeds to repurchase as many shares as possible at a price of $40.00 per share.

Assume there are no market frictions such as corporate or personal income taxes.

Part A. What is the value of APC's assets?

       
$50 million

       
$400 thousand

       
$400 million

       
$350 million

Part B. What is the debt/equity ratio under the current capital structure?

       
0%

       
15%

       
33%

       
42%

Part C. What is the debt/equity ratio under the proposed capital structure?

       
0%

       
15%

       
33%

       
42%

Part D. What is the net income under the current capital structure?

       
$25,000,000

       
$50,000,000

       
$55,500,000

       
$60,000,000

Part E. What is the net income under the proposed capital structure?

       
$25,005,000

       
$35,200,000

       
$43,500,000

       
$50,000,000

Part F. What is the EPS under the current capital structure?

       
$1.6

       
$2.5

       
$4.5

       
$5.0

Part G. What is the EPS under the proposed capital structure?

       
$4.4

       
$4.6

       
$5.8

       
$5.95

Part H. What is the ROE under the current capital structure?

       
12.0%

       
12.5%

       
13.75%

       
14.5%

Part I. What is the ROE under the proposed capital structure?

       
12.0%

       
12.5%

       
13.75%

       
14.5%

Answer 1

A

Asset value = price*shares = 10*40=400m

B

Current D/E = 0 as there is no debt

C

New D/E = Debt/(asset value-debt) = 100/(400-100) = 33%

D

Income = (EBIT)*(1-tax rate) =50000000*(1-0) = 50000000

E

Income = (EBIT-interest*debt)*(1-tax rate) = (50000000-100000000*0.065)*(1-0)=435000000

Please ask remaining parts separately. I have done one bonus

F

EPS = EBIT*(1-tax rate)/shares = 50000000*(1-0)/10000000=5

G

New shares = current shares-debt/ price = 10000000-100000000/40=

EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (50000000-100000000*0.065)*(1-0)/7500000=5.8

H

ROE = EBIT*(1-tax rate)/Market value

ROE=50000000*(1-0)/400000000

ROE=12.5

Where market value = old shares *price

I

New market value = old market value-debt

=400000000-100000000

=300000000

ROE = (EBIT-debt*interest%)*(1-tax rate)/new market value

ROE=(50000000-100000000*0.065)*(1-0)/300000000

ROE=14.5