An all-equity business has 100 million shares outstanding selling for $20 a shar

Question

An all-equity business has 100 million shares outstanding selling for $20 a share. Management believes that interest rates are unreasonably low and decides to execute a leveraged recapitalization (a recap). It will raise $1 million in debt and repurchase 50 million shares. a. What is the market value of the firm prior to the recap? What is the market value of equity? (1 point) b. Assuming the Irrelevant Proposition holds, what is the market value of the firm after the recap? What is the market value of equity? (1 point) c. Do equity shareholders appear to have gained or lost as a result of the recap? Please explain? (1 point) d. Assume now that the recap increases total firm cash flows, which adds $100 million to the value of the firm. Now what is the market value of the firm? What is the market value of equity? (1 point) e. Do equity shareholders appear to have gained or lost as a result of the recap in this revised scenario? (1 point)

Explanation / Answer

Question a. Market Value of the firm = 100,000,000 x $20 = $2,000,000,000 Market Value of equity = 100,000,000 x $20 = $2,000,000,000 Question b. Market Value of firm after recap = 50,000,000 x $20+1,000,000 = $1,001,000,000 Market Value of Equity = 50,000,000 x $20 = $1,000,000,000 Question c. Decrease in equty capital and increase in debt capital increases the Earnings per share. for example, if the company have $200 million earnings, then before recapitalization, Earnings per share was = 200/100 = $2 per share. After recapitalization EPS becomes 200/50 = $4 per shares. Question d. Market Value of the firm= 50,000,000 x $20+$100,000,000 = $200,000,000 million Market Value of Equity = 50,000,000 x $20 = $1,000,000,000

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