Question

SNC Inc., an unlevered firm, has 1 million shares outstanding, each trading at $25. The firm is thinking of changing its capital structure by issuing $10 million of debt at 10% and will use the proceeds to repurchase shares. Assume the bank pays an interest rate of 10%.

1. Assume that SNC Inc. decides to convert to the proposed capital structure. Jane, a shareholder of the firm, owns 15,000 shares. She prefers the cash flows she was receiving under the all-equity capital structure. If the EPS of the firm under the proposed capital structure is $5.50, what will be Jane’s cash flow assuming she does homemade leverage to achieve the all-equity cash flow? Assume the corporate tax rate is 0%.

Answer is $64500 – need an in-depth solution.

2. Now assume that SNC Inc. faces a corporate tax rate of 40%. What would be the stock price of SNC Inc. after the firm has announced the debt issue to the market but before the shares are repurchased?

Answer is $29 – need an in-depth solution.

Answer 1

a) Under the proposed capital structure

Value of 1 share = $25

No. of shares to be repurchased = $10 million/$25 = 400, 000 out of the existing 1,000,000 shares

i.e.40% shares will be repurchased., 600,000 shares will remain outstanding

If the capital structure changes, the total operating income will not change

Operating income of the firm as per proposed change

$5.5/share * 600,000 shares + Interest on debt

= $ 3,300,000 + 10% on $10 million = $3.3 million +$1 million =$4.3 million

$4.3 million was also the income under the earlier capital structure with 1 million shares

So, earning per share = $4.3 million/1 million =$4.3 per share

Before share repurchase, Jane's total income = $4.3/share * 15000 shares =$64500

After share repurchase, Jane will have left 60% of 15000 shares i.e. 9000 shares, and she would get $25*6000 shares by selling her shares = $150000 which can be invested in bank at 10%

So, her new earnings = earnings from 9000 shares + earnings from bank interest

=$5.5 / share * 9000 shares + $150000 * 10%

=$49500+$15000 =$64500

Thus, she can use homemade leverage to earn the same income as before changes in capital structure

b) If there are corporate taxes, as per Modigliani Miller ,

Value of a levered firm = Value of unlevered firm + tax rate * total debt

Where Levered firm is a firm with debt and unlevered firm is a firm free of debt

=> Value of Levered firm = $25 million + 40%* $10 million = $ 29 million

As the capital structure is yet to be changed, there are still 1 million shares

So, value of one share = $29 million/1 million share = $29 per share