6.12 An all-equity business has 100 million shares outstanding selling for$20 a
ID: 2750009 • Letter: 6
Question
6.12 An all-equity business has 100 million shares outstanding selling for$20 a share. Management believes that interest rates are unreasonably low and decides to execute a leveraged recapitalization (a recap). It will raise $1 billion in debt and repurchase 50 million shares.
a. What is the market value of the firm prior to the recap? What is the market value of equity?
b. Assuming the Irrelevance Proposition holds, what is the market value of the firm after the recap? What is the market value of equity?
c. Do equity shareholders appear to have gained or lost as a result of the recap? Please explain.
d. Assume now that the recap increases total firm cash flows, which adds $100 million to the value of the firm. Now what is the market value of the firm? What is the market value of equity?
e. Do equity shareholders appear to have gained or lost as a result of the recap in this revised scenario?
Explanation / Answer
A) Market value of form is 100,000,000 * $20 = $2,000,000,000 i.e 2 Billion
Market value of equity is also $2 Billion.
B) Even after Recap market value of firm will remain unchanged i.e $1 Billion in equity and $1 billion in debt.
Market value of equity is (100 million - 50 million) * $20 = $1 billion.
C) Equity shareholders have neither gained or lost because value of share still stood @$20 and they still own 100% of the company .
D) After recap and cash flow firm total value has increased to $2000 Million + $100 Million = @2100 Million and market value of equity has increased from $20 to $22 . ($1000 + $100)/50 = $22.
E) in revised scenario Equity sharegolders have gained due to increase in there share value .
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