a company currently has zero debt. It is a zero growth company with $70,000 EBIT

Question

a company currently has zero debt. It is a zero growth company with $70,000 EBIT and is considering recapitalizing with 20% debt. The money raised would cost 7% and be used to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise a full percent from its current 10%. The current price per share is $46.00 and it is in the 40% corporate tax bracket. What will the value of operations be after the recapitalization?

Explanation / Answer

Since the company has a zero growth, we can calculate the Value of operation uing constant growth version. Vop = FCF / WACC where FCF is the Future cash flows WACC is the Weighted average cost of capital Recall that FCF is the Net operatng profit after taxes (NOPAT) minus the required net investment in capital. We know that the company has an expected EBIT of $70,000 and tax rate of 40% NOPAT = $70,000 (1 - 0.40) = $70,000 (0.60) = $42,000 Since the company has zero growth, its future net investments in operating assets will be zero. So its expected FCF is equal to NOPAT. With Zero debt, the company has a WACC of 10%. Vop = $42,000 / 0.10 = $420,000 With zero debt, the value of operations of the company is $420,000. Notice that the total corporate value is calculated as: Total corporate value = Value of operations + Short-term investments = $420,000 + $0 =$420,000 Calculating the value of Debt 20% : Value of all debt = 20% ($420,000) = $84,000 The value of equity after the debt issue but before the repurchase is Value of equity prior = Total corporate value - Value of all debt = $420,000 - $84,000 It is true that the stock price per share does not change even after stock repurchase. Therefore, the price per share is $46.00 Calculating the number of shares after stock repurchase. Number of shares repurchased = Cash raised by issuing debt / Repurchase price = $84,000 / $46 = 1,826 shares

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