NEWT Company is located in a country where there are no taxes and there are perf
ID: 2723027 • Letter: N
Question
NEWT Company is located in a country where there are no taxes and there are perfect capital markets so that there are no bankruptcy costs. The corporation currently has $25 million in debt outstanding and the value of its equity is $75 million. The return on its equity is 15% and the return on its debt which is currently risk free is 8%. Suppose NEWT decides to issue $15 million additional debt and use it to repurchase $15 million of equity. The new debt is expected to be risk free after the issue. All the debt, both before and after the refinancing, consists of perpetuities.
(a) What is the total value of the firm after the refinancing? (b) What would the return on the equity be after the refinancing?
Explanation / Answer
(a) Current ROE = Net income / Value of equity
net income = ROE x Value of equity = $75 million x 15% = $11.25 million
After re-financing, value of equity = $(75 - 15) million = $60 million
Value of debt = $(25 + 15) million = $40 million
Value of firm = Value of debt + Value of equity = $(40 + 60) million = $100 million
(b) After re-financiang, there is an increase in interest expense on debt equal to ($15 million x 8%) = $1.2 million
Revised net income = $(11.25 - 1.2) million = $10.05 million
Revised ROE = Revised net income / Revised equity = $10.05 million / $60 million = 0.1675, or 16.75%
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