Buckeye Corp.is an all-equity firm which operates in a country without corporate

Question

Buckeye Corp.is an all-equity firm which operates in a country without corporate taxes where the risk-less interest rate is 10% per annum. With equal probability, it expects cash flows of $40 million in a year’s time if the going is good and expects to have cash flows of $25 million if the year is not that good. It expects to liquidate at the end of the year and distribute the liquidation proceeds along with the cash flows from operations to its shareholders. At the end of a good year, it expects liquidation value to be $28 million and $15 million otherwise. Currently, the firm is valued at $44 million and has 1,000,000 shares outstanding.

The firm is considering issuing debt with a face value of $45 million to buy out shares at market price, knowing fully well that it faces a 50% chance of defaulting on its debt. In the country where it operates, default results in court-supervised liquidation for which the courts charge a fee of 20% of the asset value liquidated. (For this purpose, any cash in the firm is not counted towards the asset value.) The net proceeds are then paid to the bondholders and the equity holders get nothing.

Buckeye’s investment bankers have recommended a promised interest of 15% for the bond but have not yet specified how much money the bond issue could raise. They will, however, charge a spread of 2% for placing the bond with investors.

Estimate the market-value based leverage of Buckeye if it goes through with its debt issue and share repurchase plan today. You can ignore any transactions costs other than the ones mentioned above and assume symmetric information and competitive securities markets.

Explanation / Answer

Options Good Not good Total Cash Flows $         40.00 $        25.00 Probability                0.50              0.50                       1.00 Expected Cashflows $         20.00 $        12.50 $                32.50 Market Value of Equity               44.00 Retained Earnings: Expected Income             32.50 Less: Interest Expenses                6.75 Less: Bank spread                0.90 Retained Earnings             24.85 Stockholders Equity             68.85 Issue of Debt capital             45.00              0.65 Leverage = 45/68.85 = 0.65

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