Benson, Athavale & Kemper (BAK) started a manufacturing facility in the last cen

Question

Benson, Athavale & Kemper (BAK) started a manufacturing facility in the last century. This firm, profitable since inception produces steering units for the automotive industry. The 3 founders have been averse to debt.

Presently, BAK has 20 million shares outstanding trading at $ 25.

The CFO Dawn Strong is looking at a proposal to buyout a competitor for $ 100 million. The entrepreneurs expect pre-tax earnings to increase by $ 20 million in perpetuity. Dawn computes the cost of capital to be 10%. She is a recent graduate from a MBA program and knows that some debt will increase the value of the firm and she plans to evaluate this project by borrowing the required funds.

Dawn finds out that the firm can sell 30 year AAA bonds with a 6% coupon. She opines that the firm with a capital structure around 25% debt will help increase its value and not worry the shareholders or the financial markets.

The firm is in the 40% tax bracket.

Construct a market value balance sheet IF debt is sold.

Explanation / Answer

Market value of equity = no. of shares outstanding*trading price

= 20 million*25 = $500 million

EBIT = $20 million. cost of capital before debt = cost of equity = 10%

BAK needs $100 million to buyout a competitor. So i am assuming that this is the amount for which bonds are issued.

So total market value of balance sheet = debt+equity. we already know the market value of equity. So now we will calculate the market value of bonds.

Discount rate for bonds discounting = cost of capital = 10%

So the market value of bond = present value of all interest payments+present value of maturity

The table below gives the pv of interest payouts:

PV of maturity value = 100/(1.1^30) = 5.73 million

Thus value of bond = PV of interest payouts + PV of maturity value = 56.56+5.73 = $62.3 million

So market value of balance sheet = market value of equity+market value of debt = $500 million+$62.3 million = $562.3 million

Issue price of bond (in $ million) Year Discount factor Coupon Rate Interest PV of interest 100 1 1.1 0.06 6 5.454545455 100 2 1.1 0.06 6 4.958677686 100 3 1.1 0.06 6 4.507888805 100 4 1.1 0.06 6 4.098080732 100 5 1.1 0.06 6 3.725527938 100 6 1.1 0.06 6 3.38684358 100 7 1.1 0.06 6 3.078948709 100 8 1.1 0.06 6 2.799044281 100 9 1.1 0.06 6 2.54458571 100 10 1.1 0.06 6 2.313259737 100 11 1.1 0.06 6 2.102963397 100 12 1.1 0.06 6 1.911784906 100 13 1.1 0.06 6 1.737986278 100 14 1.1 0.06 6 1.579987526 100 15 1.1 0.06 6 1.436352296 100 16 1.1 0.06 6 1.305774815 100 17 1.1 0.06 6 1.187068013 100 18 1.1 0.06 6 1.079152739 100 19 1.1 0.06 6 0.981047945 100 20 1.1 0.06 6 0.891861768 100 21 1.1 0.06 6 0.810783426 100 22 1.1 0.06 6 0.737075841 100 23 1.1 0.06 6 0.670068947 100 24 1.1 0.06 6 0.609153588 100 25 1.1 0.06 6 0.553775989 100 26 1.1 0.06 6 0.503432717 100 27 1.1 0.06 6 0.457666107 100 28 1.1 0.06 6 0.416060097 100 29 1.1 0.06 6 0.378236452 100 30 1.1 0.06 6 0.34385132 56.5614868

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