Question

KD Industries has 30 million shares outstanding with a market price of $20 per share and no debt. KD has had consistently stable earnings, and pays a 21% tax rate. Management plans to borrow $200 million on a permanent basis through a leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares. If KD expects the share price to increase from $20 per share to a new share price on announcement of the transaction and before the shares are repurchased, what will the new share price be after the announcement? Ans.: ______ $/share.

• A. 22.65
• B. 21.40
• C. 22.0
• D. 23.50

Answer 1

Step 1: Calculate Unlevered Value of Equity

The unlevered value of equity is calculated as below:

Unlevered Value of Equity = Number of Shares Outstanding*Price Per Share

Substituting values in the above formula, we get,

Unlevered Value of Equity = 30 million shares*20 = $600 million

______

Step 2: Calculate Value of Tax Shield

The value of tax shield is arrived as follows:

Tax Shield = Value of Debt*Tax Rate

Substituting values in the above formula, we get,

Tax Shield = 200 million*21% = $42 million

______

Step 3: Calculate Levered Value of Equity

The levered value of equity is determined as below:

Levered Value of Equity = Unlevered Value of Equity + Tax Shield = 600 + 42 = $642 million

______

Step 4: Calculate Share Price after Announcement

The share price after announcement but before actual share repurchase is calculated as follows:

Share Price = Levered Value of Equity/Number of Outstanding Shares before Actual Share Repurchase = 642/30 = $21.40

Answer is $21.40 (which is Option B).