Question

Executive Cheese has issued debt with a market value of $100.96 million and has outstanding 15.40 million shares with a market price of $10 a share. It now announces that it intends to issue a further $57.04 million of debt and to use the proceeds to buy back common stock. Debtholders, seeing the extra risk, mark the value of the existing debt down to $64 million.

a. Calculate the market price of the stock following the announcement. (Round your answer to 2 decimal places.)

Price of the stock            $

b. How many shares can the company buy back with the $57.04 million of new debt that it issues?(Enter your answer in millions. Round your answer to 1 decimal place.)

Number of shares             million

c. What is the market value of the firm (equity plus debt) after the change in capital structure?(Enter your answer in millions. Round your answer to 2 decimal places.)

Market value            $  million

d. What is the debt ratio after the change in structure? (Round your answer to 2 decimal places.)

Debt ratio            

e. Who (if anyone) gains or loses?

	The investors in the existing debt lose while the shareholders gain.
	The investors in the existing debt gain while the shareholders lose.
	No one gains or loses.

Answer 1

Please note that the value of the firm (Debt + Equity) will not change any time in the question.

All financials below are in $ mn. Nos. of shares are in mn and share price is in $.

Prior to announcement,

Debt, D₀ = 100.96; Number of shares outstanding, N₀ = 15.40; Price per share, P₀ = 10

Equity value, E₀ = P₀ x N₀ = 10 x 15.4 = 154

Value of Firm, V₀ = D₀ + E₀ = 100.96 + 154 =  254.96

a. Calculate the market price of the stock following the announcement. (Round your answer to 2 decimal places.)

Immediately after the announcement, value of the firm, V₁ = V₀ = 254.96 = D_{0, marked down} + New equity value, E_new

= 64 + E_new

Hence, E_new = 254.96 - 64 =  190.96 = P_new x N₀

Hence, new price of the stock = P_new = E_new / N₀ = 190.96 / 15.4 =  12.40

Hence, your answer should be:

Price of the stock: $ 12.40

b. How many shares can the company buy back with the $57.04 million of new debt that it issues?(Enter your answer in millions. Round your answer to 1 decimal place.)

Number of shares = New debt / P_new = 57.04 / 12.40 = 4.6 million

c. What is the market value of the firm (equity plus debt) after the change in capital structure?(Enter your answer in millions. Round your answer to 2 decimal places.)

Market value = V₀ = $ 254.96 million

d. What is the debt ratio after the change in structure? (Round your answer to 2 decimal places.)

Debt ratio = (D_{0, marked down} + New Debt) / Market Value = (64 + 57.04) / 254.96 = 47.47%

e. Who (if anyone) gains or loses?

Please choose the first option: The investors in the existing debt lose while the shareholders gain.