4. Stock Value and Leverage Green Manufacturing, Inc., plans to announce that it

ID: 2795898 • Letter: 4

Question

4. Stock Value and Leverage Green Manufacturing, Inc., plans to announce that it will issue $1.8 million of perpetual debt (the principal is never repaid) at 6% and use the proceeds to repurchase common stock. Green is currently an all-equity company worth $5.9 million with 350,000 shares of common stock outstanding. After the sale of the bonds, the company will maintain the new capital structure indefinitely. he company currently generates annual pretax earnings (i.e., EBIT) of $1.35 million. This level of earnings is expected to remain constant in perpetuity. The tax rate is 40 percent. How much annual income do all of the security holders (stock & bond holders combined) receive if Green: a. remains equity financed (U) becomes recapitalized (L) 1. 2. EBIT - Interest EBT - Tax NI +Interest Income to ALL b. What is the expected return on the company's equity before the announcement of the debt issue? In other words, what is the Green's all-equity cost of capital (WACCu or Ro)? Hint]: "all-equity company worth $5.9 million" means Vu- $5.9 million, think about the formula for Vu and extract Ro Regardless of what you got in part a, use 13.73% to find the market value of Green's as an all-equity financed company. c. Show its current capital structure: Debt EBIT (1-Tc WACC Value Equity d. Using M&M; with taxes and no bankruptcy risk, what is the present value of the interest tax shield for Green?

Explanation / Answer

Current (U) ($)

Proposed (L) ($)

EBIT – Interest

1,350,000 – 0

1,350,000 – 108,000

EBT – Tax

1,350,000 – 540,000

1,242,000 – 496,800

NI + Interest

810,000 + 0

745,200 + 108,000

Income to All

810,000

853,200

b. Return on equity = Net Income / Shareholder’s equity*100

= 810,000/5,900,000*100

= 13.73%

c. V = EBIT *(1-T) / WACC

= 1,350,000 (1-40%) / 13.73%

= $ 5.9 million

Current capital structure

Debt

$ 1.8 million

Equity

$ 4.1 million

Value

$ 5.9 million

d. Present Value of tax shield = Tax rate*No. of shares

= 0.40*350,000

= $140,000