An all equity business has 100million shares outstanding selling for $20 a share

Question

An all equity business has 100million shares outstanding selling for $20 a share. Management believes that interest rates are unreasonably low and decides to execute a leveraged recapitalization. It will raise $1 billion in debt and repurchase 50 million shares.

a. What is the market value of the firm prior to the recap? What is the market value of equity?

b. Assuming the Irrelevence Proposition holds, what is the market value of equity?

c. Do equity shareholders appear to have gained or lost as a result of the recap? Please explain

d. Assume now that the recap increases total firm cash flows, which add $100 million to the value of the firm. Now what is the market value of the firm? What is the market value of equity?

e. Do equity shareholders appear to have gained or lost as a result of the recap in this revised scenario?

Explanation / Answer

a) Market Value = 100*20 = $2000 million = $2 billion
Market value of equity would remain same = $2 billion
b) Market value would remain same after recap. Only market capitalization would reduce to half.
Market value of equity = 1 billion
c) Buying back shares increases stock price showing confidence of the company in its working. Hence, investors gets capital gains.
d) New market value = 2 billion + 100 million = 2.1 billion
Market value of equity would increase by 100 million. Hence, 1.1 billion
e) Equity shareholders have gained due to market recap

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