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

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 dividend recapitalization (a recap). It will raise $1 billion 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?

b. Assuming the Irrelevance Proposition holds, what is the market value of the firm after the recap? What is the market value of equity?

c. Do equity shareholders appear to have gained or lost as a result of the recap? Please explain.

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?

e. Do equity shareholders appear to have gained or lost as a result of the recap in this revised scenario?

Explanation / Answer

Solution:

a. Market value of the firm prior to re-cap= Number of shares outstanding*market value per share

                                                                = 100 Mn*20= $2 billion

b. Market value of the firm remains same @ $2 Billion if the irrelevance proposition holds

c. Equity shareholders appear to have gained as a result of the recap - 1. it is an avenue for private investment firms to recoup some or all of the money they used to purchase their stake in a business.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

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