Benson, Athavale & Kemper (BAK) started a manufacturing facility in the last cen

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.*

*HELP! I'm very confused by the last two questions and would really appreciate someone showing a step-by-step of how to get to the answer for each. Thank you!

Explanation / Answer

Present Capital - Full Equity- 20000000*25= 500000000 Proposal to buyout a competitor for $100 million. Initial outflow = -100000000 PV of annual increase in after-tax earnings(20000000(1-0.4))/0.10 120000000 NPV of the buyout 20000000 1. The project can be accepted as it generates positive NPV of 20000000 With Debt will give the added advantage of tax benefits on interest payments        -annually -   to the tune of 40%*(6%*25%*100000000)= 600000 The Company can save on tax to the extent of $ 600000 - if 25%of the extra money needed for the buy-out is funded through 6% Debt The project can be accepted     with debt in the capital structure 2 Market value balance sheet BEFORE the new project Assets Liabilities Common shares O/s Assets 500 Mn. 20 Mn. Shares @ $ 25 500 Mn 4.    The market value of BAKs equity will increase to 520000000 (= 500000000 + 20000000). Since BAK has 20000000 shares of common stock outstanding and the market value of the firm’s equity is 520000000, BAK's new stock price will rise to $26 per share (= 520000,000 / 20000000 shares) Market value balance sheet Just BEFORE the new project Assets Liabilities Common shares O/s OldAssets 500 Mn. 20 Mn. Shares @ $ 26 520 Mn NPV (Buyout) 20 Mn. .BAK needs to issue 100000000 worth of equity in order to fund the buyout. The market value of the firm’s stock is $26 per share after the announcement. Therefore, BAK will need to issue 3846154 shares (= 100000000 / $26 per share) in order to fund the buyout. BAK will receive 100000000 (= 3846154 shares *26 per share) in cash after the equity issue. This will increase the firm’s assets by $100000000. Since the firm now has 23846154 (= 20000000 + 3846154) shares outstanding, where each is worth $26, the market value of the firm’s equity increases to $620000004 (=23846154 shares * $26 per share). BAK's market-value balance sheet after the equity issue will be: Market value balance sheet after Equity issue for the new project Assets Liabilities Common shares O/s OldAssets 500 Mn. 23846154. Shares @ $ 26 620000004 No.of shares 23846154 NPV (Buyout) 20 Mn. Price/Share $26 Cash 100 Mn. Total 620 Mn. 620   Mn.

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