Question

Omega Co. is an all-equity firm that is expected to generate EBIT of $8 million every year forever. The company is now considering issuing debt with the amount of half the company's current value at a rate of 10%. There are currently 2 million shares outstanding. The proceeds will be used to repurchase equity. The firm's current cost of capital is 20% and corporate tax rate is 40%.

1. what is the current price per share? (before restructuring)

2. what will be its debt to equity ratio after restructuring?

3. what will their cost of equity be after restructuring?

4. what will their weighted average cost of capital be after restructuring?

5. how many shares will be repurchased? What will be the new price per share?

Answer 1

1) Calculation of the current price per share :-

Particulars	amount
EBIT	$ 8,000,000
Less- Tax@40%	$ (3,200,000)
Free cash flows	$ 4,800,000

Value of omega Co. before restructuring = FCF / cost of capital

Value of omega co. = $ 4,800,000 / 0.20

Value of omega co. before restructuring = $ 24,000,000

Value per share of omega co. before restructuring = value of firm / No. Of shares outstanding

= $ 24,000,000 / 2,000,000

Value per share of omega co. before restructuring = $ 12 per share.

2) debt to equity ratio :-

The company is now considering issuing debt with the amount of half the company's current value.

That means issue debt 50% of value & proceeds will be used for repurchase of equity.so, the capital structure is half of the equity and half of the debt of total value.

Debt to equity ratio = 50% / 50% = 1:1

Debt to equity ratio = 1:1

3) Calculation of cost of equity after restructuring :-

Calculation of Earnings available to equity share holders after restructuring :-

Particulars	amount
EBIT	8,000,000
Less - interest (12,000,000 * 10%)	(1,200,000)
EBT	6,800,000
Less - tax@40%	(2,720,000)
Earnings to equity shareholders	4,08,0000

Value of firm = 24,000,000

Value of debt =12,000,000 (half of the value of firm)

Value of equity = 24,000,000 - 12,000,000 = $ 12,000,000

Cost of equity after Restructuring = Earnings available to equity holders / value of equity

= 4,080,000 / 12,000,000

Cost of equity after Restructuring = 34%

4) calculation of weighted average cost of capital:-

WACC = weight of equity * cost of equity + weight of debt * cost of debt * ( 1- tax rate )

WACC = 0.5 * 34% + 0.5 * 10% * ( 1- 0.40)

WACC after restructuring = 20%

5) value of firm before restructuring = $ 24,000,000

Value of debt = 50% of firm value = 50% * 24,000,000 = 12,000,000

Value per share = 12 per share

The proceeds of debt is used for repurchase of shares

Shares repurchased = proceeds of debt / value per share

Shares repurchased = 12,000,000 / 12 = 1,000,000 shares.

Balance shares outstanding = 2,000,000 - 1,000,000 = 1,000,000 shares outstanding

Value per share = 12,000,000 / 1,000,000

Value per share = 12 per share