Question

Assume you have just been hired as a Finance Manager of Anjung Puteri. The company’s earnings before interest and taxes (EBIT) was RM500,000 last year and is expected to remain constant over time. Since no expansion capital will be required, Anjung Puteri plans to pay out all earnings as dividends. The management group owns fifty percent (50%) of the stock and the rest is traded in the over-the-counter market.

In your finance course, you learned that most firm owners would be financially better off if the firm used some debt. When you suggested this to your new boss, she encouraged you to pursue the idea. Anjung Puteri is currently financed with all equity, it has 100,000 shares outstanding and the current market price is RM15 per share. If Anjung Puteri were to recapitalize, debt would be used, and the funds received would be used to repurchase stock at the RM15 per share market price. Anjung Puteri is in a 24% tax bracket. The company leases all its equipment and its building. Therefore, Anjung Puteri has no depreciation expense.

From your finance training, you know that there is an optimum relationship between debt and equity at which the market value per share will be maximized. You recall that you can use estimated cash flows, weighted average cost of capital (WACC), and the capital asset pricing model (CAPM) to estimate share value. As a first step you found the following information on Yahoo finance:

“The current prime borrowing rate is 5.14% and the current risk-free rate (10 year Malaysia Government bond) is 3.07%. You estimate the market risk premium into the foreseeable future at 8%.

Next, you obtained from a local investment banker the following estimated debt risk premiums and subjective betas for Anjung Puteri at various debt levels:

Scenario	Amount Borrowed (RM)	Debt Risk Premium (%)	Subjective Beta
1	0	2.0	2.0
2	187,500	2.0	2.1
3	375,000	2.5	2.3
4	562,500	3.5	2.5
5	750,000	5.0	2.9
6	937,500	7.0	3.3
7	1,125,000	10.0	3.7

Required:

1. It is also useful to determine the effect of recapitalization on earnings per share. Calculate the EPS under each debt scenario.

Answer 1

		A	B	C=B+5.14%	D=A*C	E	F=E-D	G=F*(1-0.24)	H=A/15	I=100000-H	J=G/I
	Scenario	Amount borrowed	Debt Risk Premium(%)	Borrowing Rate(%)	Amount of Interest Expenses	EBIT	Earning after Interest before Tax	Net Income	Number of Shares Repurchased	Number of shares Outstanding after repurchase	Earning Per Share(EPS)
	1	0	2.0%	7.14%	0	500,000	500,000	380,000	0	100000	3.80
	2	187,500	2.0%	7.14%	13388	500,000	486,613	369,826	12500	87500	4.23
	3	375,000	2.5%	7.64%	28650	500,000	471,350	358,226	25000	75000	4.78
	4	562,500	3.5%	8.64%	48600	500,000	451,400	343,064	37500	62500	5.49
	5	750,000	5.0%	10.14%	76050	500,000	423,950	322,202	50000	50000	6.44
	6	937,500	7.0%	12.14%	113813	500,000	386,188	293,503	62500	37500	7.83
	7	1,125,000	10.0%	15.14%	170325	500,000	329,675	250,553	75000	25000	10.02