Benson, Athavale & Kemper (BAK) started a manufacturing facility in the last cen
ID: 2766846 • Letter: B
Question
Benson, Athavale & Kemper (BAK) started a manufacturing facility in the last century. This firm, profitable since inception produces steering units for the automotive industry. The 3 founders have been averse to debt.
Presently, BAK has 20 million shares outstanding trading at $ 25.
The CFO Dawn Strong is looking at a proposal to buyout a competitor for $ 100 million. The entrepreneurs expect pre-tax earnings to increase by $ 20 million in perpetuity. Dawn computes the cost of capital to be 10%. She is a recent graduate from a MBA program and knows that some debt will increase the value of the firm and she plans to evaluate this project by borrowing the required funds.
Dawn finds out that the firm can sell 30 year AAA bonds with a 6% coupon. She opines that the firm with a capital structure around 25% debt will help increase its value and not worry the shareholders or the financial markets.
The firm is in the 40% tax bracket.
1. Should BAK accept the project? With debt or with sale of shares? Explain?
2. Construct a market value balance sheet BEFORE the new project.
3. Construct a market value balance sheet IF debt is sold.
4. Construct a market value balance sheet IF equity is sold. Compute the number of share to be sold and the NEW price of the share.
Explanation / Answer
Since the project has positive net present value, it advisable to accept the project.
Accept the project with debt, by issuing or selling 30 year bonds with a 6%, as the she projected correctly the having debt has advantage over non leavered , because of tax offect on debt expenses.
It is advisable to finance the project by issuing bond.
Calculation of NPV:
Cash flows are $20 million perpetuity and cost of capital be 10%
NPV = -100 million + $20 million / 0.1
NPV = -100 million + $200 million
NPV = 100 million.
Market value balance sheet BEFORE the new project.
Equity and Liabilities:
Liabilities:
Equity:
Share capital (20 million share of $25) = $500 million
Market value balance sheet IF debt is sold.
Equity and Liabilities:
Liabilities:
Long term bonds:
6% bonds with 30 years = $100 million
Equity:
Share capital (20 million share of $25) = $500 million
Market value balance sheet IF equity is sold
Equity and Liabilities:
Liabilities:
Long term bonds:
Equity:
Share capital (20 million share of $25) = $500 million
New share capital (4 million share of $25 each) = $100 million
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