Garnett Corporation is planning to repurchase part of its common stock by issuin

Question

Garnett Corporation is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firm’s debt-to-equity ratio is expected to rise from 40 percent to 50 percent. The firm currently has $3.8 million worth of debt outstanding. The cost of this debt is 7 percent per year. Garnett expects to have an EBIT of $1.37 million per year in perpetuity. Garnett pays no taxes. a. What is the market value of the company before and after the repurchase announcement? b.What is the expected return on the firm’s equity before the announcement of the stock repurchase plan? c.What is the expected return on the equity of an otherwise identical all-equity firm? d. What is the expected return on the firm’s equity after the announcement of the stock repurchase plan?

Explanation / Answer

Present:

Debt=$3.8 Million

Cost of debt=7%

so Interest=$3.8 million*7%=$ 0.266 Million

so EBt=$1.37-$0.266=$1.104 Million

Equity=$3.8 Million*0.6/0.4=$5.7 Million

so the expected return on the firm’s equity before the announcement of the stock repurchase plan=$1.104/$5.7=0.1937=19.36%

so WACC=19.36%*.6+7%*0.4=14.42%

so  the market value of the company before the repurchase announcement=EPS/WACC=$1.37 Million/14.42%=$9.501 million

Proposed:

Debt =$3.8 Million

so the debt equity ratio became 0.5

so Equity =$3.8 Million

so the amount to be repurchased=$5.7 million -$3.8 Million=$1.9 Million

expected return on the firm’s equity after the announcement of the stock repurchase plan=$1.104 Million/$3.8 Million =0.2905=29.05%

WACC=29.05%*0.5+7%*0.5=18.03%

the market value of the company after the repurchase announcement=$$1.37 Million/18.03%=$ 7.598 million=$7.6 Million(round)

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