Question

Magic Production Company (MPC) is considering a recapitalisation plan that would convert MPC from its current all-equity capital structure to one including some financial leverage. MPC now has 6 million ordinary shares outstanding, which are selling for $50.00 each. Currently, MPC shareholders have a required return of 15%. The expected earnings before interest and taxes (EBIT) of MPC is $45,000,000 per year for the foreseeable future.
The recapitalisation proposal is to issue $100,000,000 worth of long-term debt at an interest rate of 7.5 per cent and use the proceeds to repurchase as many shares as possible at a price of $50.00 per share. Assume there are no market frictions such as corporate or personal income taxes.
(i) Calculate the number of shares outstanding and the debt-to-equity ratio for MPC if the proposed recapitalisation is adopted.

(ii) Calculate the expected earnings per share (EPS) and the expected return on equity (ROE) for MPC shareholders under the proposed mixed debt/equity capital structure. How does it compare to the EPS and ROE under the current capital structure?

(iii) Calculate the break-even level of EBIT where earnings per share for MPC shareholders are the same under the current and proposed capital structures.

For the next question assume Magic Production Company (MPC) is subject to a 40% corporate income tax rate.
(iv) How does financial leverage increase the value of MPC in the presence of corporate income taxes? Explain.

Please show your calculations clearly.

Answer 1

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