M Company is financed entirely by common stock that is priced to offer a 20% exp

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.

Explanation / Answer

Question 23)

Step 1: Calculate Revised EPS and Revised Return

The revised earnings per share after repurchase would be $19.20. It has been calculated as follows:

Revised EPS = (Current EPS - Interest on Debt)/.5 [where .5 indicates the shares outstanding after the repurchase) = (12 - 8%*50%*60)/.5 = $19.20

The revised return can be calculated with the use of following formula:

Revised Return = Revised EPS/Stock Price*100 = 19.20/60*100 = 32%

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Step 2: Determine the Portfolio the Investor Needs to Achieve to Retain 20% Return

The equation for weighted return can be used to detemine the portfolio. The equation is given below:

Weighted Return = Retun on Equity after Repurchase*Weight of Equity + Return on Debt*Weight of Debt

Here, Weighted Return = 20%, Retun on Equity after Repurchase = 32%, Weight of Equity = X, Return on Debt = 8% and, Weight of Debt = 1-X

Substituting these values in the above equation, we get,

20% = 32%*X + 8%*(1-X)

or 20% = 32%X + 8% - 8%X

Rearranging Values, we get,

X = (20% - 8%)/(32% - 8%) = 50%

Therefore, Investment in Equity (X) would be 50% and Debt (1-X) would be 50%.

As a result, the investor would sell 50% of his equity and buy 50% of debt to achieve a return of 20%.

His current equity holding is $6,000 (100 Shares*60) which would become 50 Shares (100*50%) as 50% would be sold and debt would be $3,000 (investment in debt)

Answer is Sell 50 Shares and Purchase $3,000 Debt (Bonds) (which is Option B)

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Question 24)

The selected answer is correct. Option C is the correct answer.

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