Consider a firm that has an EBIT of $3,000,000 per year for ever. There are 1,00

Question

Consider a firm that has an EBIT of $3,000,000 per year for ever. There are 1,000,000 shares outstanding. The firm also has $10 million of perpetual debt with an interest rate of 8 percent (also its coupon rate) in its capital structure. At the existing capital structure, the firm’s cost of equity is 12 percent and the cost of debt is 8 percent. The firm faces a tax rate of 30 percent. The firm announces that it wishes to raise the debt level to $14 million. The old debt will be retired and the firm will issue another $14 million of new debt and use the proceeds to buy back shares. At the higher debt level, the cost of debt is expected to be 9 percent and the cost of equity 13 percent. (i) What is the value of the firm before the capital structure change and what is the stock price? (ii) What will be the value of the firm and the stock price after the capital structure change? (iii) How many shares will be outstanding after the capital structure change and what will be the firm’s debt to asset ratio?

Consider a same firm as above. The firm announces that it wishes to raise the debt level to $14 million. However, the old debt will be not be retired and the firm will issue another $4 million of new debt and use the proceeds to buy back shares. At the higher debt level, the cost of debt is expected to be 9 percent and the cost of equity 13 percent. (iv) What will be the value of the firm and the stock price after the capital structure change? (v) How many shares will be outstanding after the capital structure change and what will be the firm’s debt to asset ratio?

Explanation / Answer

i) Here EBIT=$3000000

Outstanding shares=1000000

cost of debt=8% cost of equity=12%

debt =10 million Tax Rate(T)=30%

EBT=EBIT-Interest =3000000-800000=2200000

PAT=2200000(1-T)=2200000*0.7=1540000

now value of equity=1540000/cost of equity=1540000/0.12=12833333

value of firm =market value of equity+market value of debt=12833333+10000000~$38.83million

stock price=value of equity/no of shares outstanding=12833333/1000000=$12.83

ii)Now the debt is 14million

raising 14 million of debt will allow the firm to buyback all the shares outstanding

EBIT=$3000000

EBT=EBIT-interest=3000000-1260000=1740000

PAT=EBT*0.7=1218000

value of equity=1218000/0.13=9369231

value of debt=14000000, value of firm=14000000+9369231~23.36million

iii)the number of shares outstanding will be zero and firms debt-to-asset ratio will be

14000000/23.36million =0.59

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