HoneyBowl Corporation has perpetual earnings before interest and taxes (EBIT) of
ID: 2651292 • Letter: H
Question
HoneyBowl Corporation has perpetual earnings before interest and taxes (EBIT) of $5,000,000. It has since had no debt in its capital structure, and its cost of equity is 15%. The corporate tax rate is 40%. There are 1,000,000 common shares outstanding. HoneyBowl has announced that it will borrow $4,000,000 in perpetual debt at 8% and use the proceeds to buy back some of its shares.
a) Compute the value of HoneyBowl Corporation before the acquisition of debt.
b) Compute the value of the firm after it has successfully issued the perpetual debt.
c) What is the estimated price per share after the recapitalization (that is, after the debt issue)?
d) How many shares will the company be able to repurchase?
Please provide the formulas and show each step.
Thank you!
Explanation / Answer
a)Value of Hney bowl Corporation before debt : EBIT(1-Tax)/Cost of equity
= 5000000(1-.40)/.15
= 3000000/.15
= $ 20,000,000
b)Value of firm after issue of debt :(EBIT-interest )(1-Tax) /Cost of equity
= (5000000-320000)(1-.40)/.15
=4680000(.60)/.15
=2808000/.15
=$ 18,720,000
c)Estimated price per share = (Overall value of firm after debt issue - Value of debt )/Number of shares outstanding
= (18720000-4000000)/100000
= 14720000/100000
=147.20 per share
d)Number of shares that can be purchased: Value of debt raised /Market price per share
4000000/147.20
= 27174 shares
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