M Company is financed entirely by common stock that is priced to offer a 20% exp
ID: 2776505 • Letter: M
Question
M Company is financed entirely by common stock that is priced to offer a 20% expected rate of return. The stock price is $60 and the earnings per share are $12. The company wishes to repurchase 50% of the stock and substitutes an equal value of debt yielding 8%. Suppose that before refinancing, an investor owned 100 shares of the company's common stock. What should he do if he wishes to ensure that risk and expected return on his investment are unaffected by refinancing? Buy 100 shares and invest $3,000 in bonds Sell 50 shares and purchase $3,000 debt (bonds) Borrow $3,000 and buy 50 more shares Continue to hold 100 shares There is nothing that he could do The possibility of bankruptcy has a negative effect on the value of the firm because Increased bankruptcy risk lowers project cash flows. Reorganization is costless but risk is not. A bankruptcy has real costs associated with it. Value enhancing strategies are no longer available. A, Band C.Explanation / Answer
(Q-23)
(‘E)- There is nothing that he can do.
If the company’s net earnings before interest is the same, then there is no impact on wealth of existing shareholder. Because reduction in the number of share will increase the earnings per share, and thus worth of shareholder remain unchanged.
Let’s assume company has total 1000 common stock of outstanding before refinancing.
Particulars
Before Refinancing
After Refinancing
EBIT
12,000
12,000
Number of share holder
1000
5000
Value of Debt
0
3000 ( 500 shares x $60 )
Interest
0
2400 ( 3000 x 0.08)
Net Earnings
12,000
9,600
EPS
12.00
19.20
Wealth of Existing shareholder having 100 shares before refinancing
Particular
Before Refinancing
After Refinancing
Earning through share
12,00 (100 x $12 )
960 ( 50 x $ 19.20)
Earning through interest income on bonds
0
240 ( 3000 x 0.08)
Total Earnings
1,200
1,200
Thus in both case worth of portfolio remains same.
(’24) Bankruptcy- For each company there is in optimum capital structure which includes debt and equity. Debt has a tax advantage hence sometimes company’s prefer debt instead of equity financing. The thinking behind more debt and less equity is to take the tax advantage of debt and to reduce the dilution of ownership. Bankruptcy is a recognition that the promised payment committed to debt holders are greater than the value of assets.
There are two types of cost associated with bankruptcy.
Direct Cost- In the case of risk of bankruptcy debt holders have a right to be paid first out of the assets. In case of bankruptcy maturity of debt might be lengthened, in sometimes rate of interest is also increased to compensate the postponement of interest payments. These are direct cost associated with it.
Indirect Cost- Lost of customers because if commitment to customers is not met then customers are not willing to purchase the product of organisation. In this case cash inflows are reduced significantly. Similarly loss of suppliers also reduces the inventory as supplier may think that they might not be paid. Hence it can be said reduction in the cash flow is an indirect cost associated with bankruptcy.
Reorganisation of capital structure is always carries some risk if debt portion increased.
Hence it can be said that right answer is option E.
Particulars
Before Refinancing
After Refinancing
EBIT
12,000
12,000
Number of share holder
1000
5000
Value of Debt
0
3000 ( 500 shares x $60 )
Interest
0
2400 ( 3000 x 0.08)
Net Earnings
12,000
9,600
EPS
12.00
19.20
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