Use the following information to respond to the next four multiple choice questi

Question

Use the following information to respond to the next four multiple choice questions. Firm R currently has $1,000,000 of debt outstanding with a before tax annual coupon of 5%, a constant EBIT of $2,100,000 and 500,000 shares outstanding at a market price of $20.00. The firm is considering issuing $2,500,000 of debt at a before tax cost of 7% and using the proceeds to repurchase stock at the new post-announcement market price. If this plan is implemented, it is expected that the required return on equity would rise to 9%. The firm's marginal tax rate is 34%..

1.What is the market value of the firm before the announcement of the issue of the new debt?

2. What is the estimated value of the firm after the new debt issue?

3. What is the estimated share price after the capital structure change?

4. How many shares remain outstanding after the capital structure change?

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

= 500,000 * 20 = $10,000,000

Market Value of the Firm = 1,000,000 + 10,000,000 = $11,000,000

2) Now the company issues new debt of $2.5million at 7%

EBIT = $2,100,000

Interest Cost = 5% on old debt and 7% on new debt

                    = (5% * 1,000,000) + (7% * 2500,000)

                    = $225,000

Net Profit = (EBIT - Interest)* (1-Tax Rate)

              = (2100,000 - 225,000) * (1 - 0.34)

              = $1,237,500

Now, it is given that the cost of equity becomes 9% after additon of new debt

Cost of Equity = Net Profit / Maret Value of equity

Market Value of Equity = Net Profit / Cost of Equity

                 = 1237500 / 0.09= $13750000

So, the new market value of the firm = $13750000+ $2725000 = $16475000

3) Price of 1 share = $20

Number of shares that can be purchased with $3million = 500000 / 20 = 187500approx.

Number of Outstanding shares = 2725000 - 187500= 160250

Estimate New Share Price = Market Value of Equity / Number of Outstanding Shares

                                          = 13750000 / 160250 = $85.80 approx.

4) Price of 1 share before repurchase= $20

Number of shares that can be purchased with $3million = 2100000 / 20= 105000approx.

Number of Outstanding shares after repurchase = 2725000 - 105000 = 170000

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