Manitoba Oil Corp. (MOC) is a small petroleum exploration and development compan

Question

Manitoba Oil Corp. (MOC) is a small petroleum exploration and development company operating in the southwest corner of the province. It has three million common shares outstanding, and perpetual debt with a market value of $30 million. Its interest rate is 8%, and its corporate tax rate is 40%. Its levered beta is 1.2. The risk-free rate is 3% and the market portfolio return is 12%. MOC’s EBIT is expected to be $10 million every year, and MOC pays out all earnings as dividends to shareholders. MOC’s competitors have an average market-value-based debt-to-asset ratio of 20%. The CFO would like to decrease MOC’s debt-to-asset ratio to the industry norm to decrease risk. This would mean issuing additional equity and paying off some debt.

a) Calculate the current cost of equity, value of equity, price per share, total value of MOC, and MOC’s debt-to-asset ratio.

b) Calculate the total value of equity that MOC should issue to decrease the debt-to-asset ratio to the industry standard. Calculate the share price following the issue of additional equity. Explain why the share prices changes the way it does.

Explanation / Answer

a)Current cost of equity =Risk free rate +beta(market return -risk free rate)

                                = 3 + 1.20(12 -3)

                                = 3 + 10.8

                               = 13.8 %

a2)EBT =EBIT - Interest

            = 10 million- (30million* .08)

            = 10 - 2.40

           = 7.60

EAT =EBT (1- tax)

    = 7.60 (1-.40 )

     =$ 4.56

Value of equity = EAT /cost of equity

                      = 4.56 /.138

                     = 33.04 million

price per share = Value of equity /number of share outstanding

                      = 33.04 / 3

                       = $ 11.01 per share

Total value of MOC =value of equity +debt

                           = 33.04 +30

                           = $ 63.04 million

Debt to asset ratio =Debt /asset

                            = 30 / 63.04        [Total asset =total liabilit +equty]

                            = .4759 or 47.59%

b)debt to asset ratio =debt /asset

     .20 = 30 /(30 +X)

      30+X= 30/.20

    X= 150-30

       =$ 120 million

New equity to be issued= 120 -33.04

                                    = $ 86.96 million

share price = Total equity /number of shares

                 = 120 / 3

                  = $ 40 per share

price of equity per share increases as value of debt decreases (or proportion of debt decreases ) .therefore value of equity increases .

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