Currently, the firm is all equity funded with 500000 shares valued at $10 per sh

Question

Currently, the firm is all equity funded with 500000 shares valued at $10 per share and the required return on equity is 15.6%. Income tax rate is 40%. Your banker has indicated that the following leverage restructurings are possible:

Debt Leverage Interest
ROE

10.00% 8.50% 16.00%

20.00% 9.00% 17.00%

30.00% 9.50% 19.00%

Estimate the share prices for the following debt restructures 10%, 20%, and, 30%, respectively:

A $10.44; $10.68; $10.48

B $10.68; $10.48; $10.44

C $10.68; $10.44; $10.48

D $10.48; $10.68; $10.44

E $10.44; $10.48; $10.68

Estimate which two debt restructures maximize firm value.

A. 0%; 10%

B. 20%; 30%

C. 30%; 0%

D. 10%; 20%

E. 0%; 20%

Please inlcude the steps involved in solving the question. Thanks in advance!!

Explanation / Answer

All equity fund = 500,000 * 10 = 5000,000

Then required return = 5000,000 * 15.6% = 780000

Earning before tax = 780000 / ( 1 - 0.40) = 780000 / 0.6 = 13,00,000

Option - D ..........is the correct option

Estimate which two debt restructures maximize firm value.

At 0% debt, we have firm value = 5000,000 but it is more than that in the cases of 10% and 20%

D. 10%; 20% ..............is the correct choice

NOTE: ..........We have decrease in firm value at 30%, It cannot be selected.

(1) Market value of equity is calculated by multiplying price per share * number of shares.

(2) Market value of debt = 10% , 20% and 30% calculated on 5000,000.

(3) Number of shares are calculated as 90%, 80% and 70 of 500,000 shares.

10% 20% 30% Amount of Debt 500000 1000000 1500000 Interest rate 8.5 9 9.5 EBIT 1300000 1300000 1300000 (-) Interest 42500 90000 142500 EBT 1257500 1210000 1157500 (-) Tax   ( 40% of Tax) 503000 484000 463000 EAT 754500 726000 694500 Number of shares 450000 400000 350000 EPS 1.676667 1.815 1.984286 Ke 0.16 0.17 0.19 Share price = EPS/Ke 10.48 10.68 10.44

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