XYZ Ltd is currently all equity financed with a market value of $1 million. Its

Question

XYZ Ltd is currently all equity financed with a market value of $1 million. Its management is

considering the issue of bonds with a face value of $500,000 (issued at face value). The new funds

raised will be used to repurchase shares from existing shareholders.

a) Illustrate the effect of leverage in a world with no taxes by sketching the relationship between

the cost of equity and leverage for the all equity situation and the proposed (50% debt, 50%

equity) on a fully labeled graph.

All firms face business risk. What additional risk do shareholders face under the proposed

structure? Illustrate the second of these two risks by rearranging the weighted average cost of capital equation

Explanation / Answer

1) Due to issue of bonds the earnings of the company will decrease as now the company will have to pay interest on bonds and as said in tax free world the company will not even get tax benefit on interest expense . On the same side bonds are issued to repurchase shares from existing shareholders this will reduce the number of shareholders due to which each shareholder will get more income as compared to earlier scenario

Example : Case 1 all equity financed company

Ebit = 5000000

Earning available for equity shareholders = 5000000

Earning per share = 5000000/100000

= 50

Case 2 : bonds bearing interest 10% issued to repurchase stock

Earning before interest and tax = 5000000

Interest paid on bonds = ( 500000*10%) i.e 50000

Earning available for equity shareholders = 4950000

Earning per share after repurchase = 4950000/50000

= 99

Eps is increasing in the second case

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