As Chief Financial Officer of the Magnificent Electronics Corporation(MEC), you

Question

As Chief Financial Officer of the Magnificent Electronics Corporation(MEC), you are considering a recapitalization plan that would convert MEC from its current all-equity capital structure to one including substantial financial leverage. MEC now has 500,000 shares of common stock outstanding, which are selling for $60 each, and you expect the firm's EBIT to be $2,400,000 per year, for the foreseeable future. The recapitalization proposal is to issue $15,000,000 worth of long-term debt, at an interest rate of 6% and then use the proceeds to repurchase 250,000 shares of common stock worth $15,000,000. Assuming there are no market frictions such as corporate or personal income taxes, calculate the expected return on equity for MEC shareholders, under both the current all-quity capital structure and under the recapitalization plan.

Explanation / Answer

Here it is: If MEC issues $15,000,000 worth of debt and repurchases 250,000 shares of stock worth $15,000,000, this implies that the shares will be repurchased at a price of $60 each ($15,000,000 / 250,000 shares = $60). After this transaction, 250,000 shares will remain outstanding, each worth $60, for a total equity value of $15,000,000. The debt-to-equity ratio will therefore be 1.0 ($15,000,000 debt / $15,000,000 equity).

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