Question

Taco Salad Manufacturing, Inc., plans to announce that it will issue $2.11 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 9 percent. The company is currently all-equity and worth $6.58 million with 194,000 shares of common stock outstanding. After the sale of the bonds, the company will maintain the new capital structure indefinitely. The annual pretax earnings of $1.35 million are expected to remain constant in perpetuity. The tax rate is 25 percent.

d-1. How many shares will the company repurchase as a result of the debt issue? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

d-2. How many shares of common stock will remain after the repurchase? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

g. What is the required return on the company’s equity after the restructuring? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

1. Value of levered Firm = Value of Unlevered Firm + Debt * tax Rate

Value of levered Firm = $6.58 Million + $2.11 M * 25%

Value of levered Firm = $6.58 Million + $0.5275 M

Value of levered Firm = $7.1075 M

2. Value of Equity = Value of Levered Firm - Debt Value

Value of Equity = $7.1075 M - $2.11M

Value of Equity = $4.9975 M

3. Purchase price of Share = Value of Equity / Shares O/s = $4.9975 M / 0.194 M

Purchase price of Share = $25.76 per Share

d-1. How many shares will the company repurchase as a result of the debt issue? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Shares Repurchased = Debt / Share Price = $2.11 M / 25.76 = 81909.95 Shares

d-2. How many shares of common stock will remain after the repurchase? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Shares after Repurchase = Current Shares O/s - Shares Repurchased = 194000 Shares - 81909.95 = 112091.05 Shares

g. What is the required return on the company’s equity after the restructuring? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

ROE = (Earnings - Interest) * (1 - Tax) / Value of Equity

ROE = (1350000 - 189900) * (1 - 0.25) / $4.9975 M

ROE = 17.41%

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