Benson, Athavale & Kemper (BAK) started a manufacturing facility in the last cen
ID: 2645418 • Letter: B
Question
Benson, Athavale & Kemper (BAK) started a manufacturing facility in the last century. This firm, profitable since inception produces steering units for the automotive industry. The 3 founders have been averse to debt.
Presently, BAK has 20 million shares outstanding trading at $ 25.
The CFO Dawn Strong is looking at a proposal to buyout a competitor for $ 100 million. The entrepreneurs expect pre-tax earnings to increase by $ 20 million in perpetuity. Dawn computes the cost of capital to be 10%. She is a recent graduate from a MBA program and knows that some debt will increase the value of the firm and she plans to evaluate this project by borrowing the required funds.
Dawn finds out that the firm can sell 30 year AAA bonds with a 6% coupon. She opines that the firm with a capital structure around 25% debt will help increase its value and not worry the shareholders or the financial markets.
The firm is in the 40% tax bracket.
Should BAK accept the project? With debt or with sale of shares? Explain?
Explanation / Answer
Pretax earning expected to be increased in perpetuity, if the project is acceped = $20 million
The firm is in 40% tax bracket.
So after tax earnings that is expectedto be increased in perpetuity = 20 ( 1- 0.40) = $12 million
Since Dawn is an all equity firm and it computes cost of capital to be 10%, cost of equity = 10%
Investment = $100 million
ROI of the project
= After tax Income / Investment
= $12/ $100 = 12%
ROI of the project (12%) is greater than the cost of capital (10%).
Moreover the return being perpetuity,
The PV of the project = 12/ 0.10 = $120 million
which is greater than the initial investment of $100 million
BAK should accept the project.
If the project is financed by equity then overall cost of capital of the firm is 10%
If the project is financed by debt capital so that the capital structure is leveraged by 25% debt with 6% coupon, the overall cost of capital of the firm will be
= proportion of equity x cost of equity + proportion of debt x after tax cost of debt
= 0.75 x 10% + 0.25 x 6% ( 1- 0.40)
= 7.5 % + 0.9%
= 8.4%
So the overall cost of capital reduces to 8.4% if 25% of debt is used in the capital structure of the firm. With a decrease in the overall cost of capital the value of the firm will increase.
Increase in EPS under the equity option:
Number of shares to be issued to raise $100 million = 100/25 = 4 million
Increase in after tax income = $12 million
Increase n EPS = $12 million / 24 million = $0.50
Increase in EPS under Debt financing:
After tax earnings = ( 20 - 6) (1 - 0.40) = $8.4 million, where $6 million is the interest to paid the the bondholders.
Increase in EPS = $8.4 million / 20 million = $ 0.42,
It is being observed that the EPS will increase in both the cases but with equity financing the EPS will increase better.
Still the company should go for the debt financing, because the EPS will increase and the less increament of EPS by $0.08 per share wil not worry the shareholders, as issuing debt will not dilute the control of the shareholders and the reduction of the overall cost of capital because of leveraging will also increase the value of the firm.
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