Catto Hogg Inc. (CHI) has been 100% equity owned but recently made changes to it

Question

Catto Hogg Inc. (CHI) has been 100% equity owned but recently made changes to its capital structure. You have collected the following information:

- CHI issued $12,000,000 in new debt to buy back stock

- The firm had no short-term investments before or after the recapitalization

- CHI had 1,500,000 shares outstanding before the recapitalization

- CHI's capital structure now has 20% debt

- The company's operations are valued at $60 million after recapitlization

1. Based on the information available, solve for the values in the following table.

Now consider this case:

2. CHI decides to deleverage in the future, the total number of shares outstanding will keep decreasing until creditors own 100% of the company.

Is this statement true or false?

Explanation / Answer

CHI has issued new debt of $12,000,000 to replace common stock of same worth in its capital structure through buy-back. This is called leveraging the capital structure of busniess. This $12 million represents 20% of company's new capital structure post re-capitalization exercise; thus multiplying $12 million by 5 times [because 100% / 20% = 5 times], we get company's total capital amount of $60 million [entirely equity capital value prior to recapitalization exercise].............................. ANSWER

Thus, $60,000,000 if divided by 1,500,000 equity shares outstanding before re-capitalization exercise gives $40 per equity share i.e. Book-Value per equity share. At this price, $12,000,000 [proceeds of newly issued debt] would buy-back 300,000 equity shares i.e. $12,000,000 / $40 per equity share. ................ ANSWER

Post re-capitalization exercise, (1,500,000 - 3,00,000) equity shares remian outstanding in company's capital structure i.e. 1,200,000 equity shares.

Modigliani-Miller Proposition I states that in the absence of taxes, the value of a levered firm equals the value of an otherwise identical unlevered firm.

Modigliani-Miller Proposition I (No Taxes):   VL =VU

Because it is given that market value of company's operations is $60 million after re-capitalization and from above-mentioned Modigliani-Miller Proposition I (No Taxes), market value of company's operations before re-capitalization is also equal to $60 million attributable entirely to equity shareholders' capital. Dividing this amount by number of equity shares outstanding before re-capitalization exercise= $60,000,000 / 1,500,000= $40 per equity share, which is company's stock price before re-purchase ....................... ANSWER

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.