Firm C currently has 320,000 shares outstanding with current market value of $33
ID: 2612472 • Letter: F
Question
Firm C currently has 320,000 shares outstanding with current market value of $33 per share and generates an annual EBIT of $1,500,000. Firm C also has $1 million of debt outstanding. The current cost of equity is 9 percent and the current cost of debt is 6 percent. The firm is considering issuing another $3 million of debt and using the proceeds of the debt issue to repurchase shares (a pure capital structure change). It is estimated that the cost of the new debt will be 7 percent and that the cost of equity will rise to 10 percent with the additional debt. The marginal tax rate is 34 percent.
1. What is the current market value of the firm?
2. What will the firm’s market value be after the announcement of the new debt issue? (Note that total market value of debt will be D0 + D1 and the interest costs that must be subtracted from EBIT when calculating the market value of equity must be calculated in two parts and then added: Kd0D0 + Kd1D1).
3. What will the estimated new share price be after the capital structure change announcement?
4. How many shares are outstanding after the repurchase?
Explanation / Answer
1) Market Value of the Firm = Market Value of Debt + Market Value of Equity
Market Value of Equity = Number of shares outstanding * Share Price = 320,000 * 33 = $10,560,000
Market Value of the Firm = 1,000,000 + 10,560,000 = $11,560,000
2) Now the company issues new debt of $3million at 7%
EBIT = $1,500,000
Interest Cost = 6% on old debt and 7% on new debt
= (6% * 1,000,000) + (7% * 3,000,000)
= $270,000
Net Profit = (EBIT - Interest)* (1-Tax Rate)
= (1,500,000 - 270,000) * (1 - 0.34)
= $811,800
Now, it is given that the cost of equity becomes 10% after additon of new debt
Cost of Equity = Net Profit / Maret Value of equity
Market Value of Equity = Net Profit / Cost of Equity
= 811,800 / 0.1 = $8,118,000
So, the new market value of the firm = $8,118,000 + $4,000,000 = $12,118,000
3) Price of 1 share = $33
Number of shares that can be purchased with $3million = 3000000 / 33 = 90909 approx.
Number of Outstanding shares = 320,000 - 90909 = 229091
Estimate New Share Price = Market Value of Equity / Number of Outstanding Shares
= 8,118,000 / 229091 = $35.44 approx.
4) Price of 1 share before repurchase= $33
Number of shares that can be purchased with $3million = 3000000 / 33 = 90909 approx.
Number of Outstanding shares after repurchase = 320,000 - 90909 = 229091
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.