LikeABath generates $30,000,000 in perpetual operating income (i.e., no change i

Question

LikeABath generates $30,000,000 in perpetual operating income (i.e., no change in investment policy). The company has a market capitalization of $100,000,000, and its share is currently selling at $100 per share. The company has $100,000,000 in debt obligation, with an interest rate of 10%. The company wants to increase its leverage by repurchasing 200,000 shares of its outstanding stock at the prevailing market price ($100 per share) and plans to finance the equity repurchase by issuing $20,000,000 bond at 10%.

1. How can investors undo the effect of LikeABath's capital structure change?

2. What obstacles will investors run into in real life, preventing them from completing the necessary transactions to undo LikeABath's capital structure change?

Explanation / Answer

Change In Capital structure - No effect on income from operations.

The capital investment projects undertaken by the firm are usually financed with some combination of debt and equity. In order to understand the effect of this choice on the value of the firm, consider the case where the firm is currently financed entirely (100 percent) by equity. We will also assume that the firm's production capacity is already in place (i.e., the investment decision by the firm is a given) so that any changes in the firm's financing mix (such as replacing equity with debt financing) will have no impact on the cash flows from operations

The implications of the “recapitalization” (change in financing mix) on taxes

If no debt had been issued, the firm would have to pay corporate taxes on the Income, In other words, Interest on bond is tax deductible item. Dividend to shareholders is not tax deductible consequently company has to pay more taxes.

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