A firm currently has no debt. The firm has 15 million shares outstanding and tho

Question

A firm currently has no debt. The firm has 15 million shares outstanding and those shares currently have a market price of $25 per share. The firm is contemplating selling $50 million in bonds and using the proceeds to repurchase shares of stock. If they undertake this action, the firm intends to keep this level of debt financing for the foreseeable future. Assume that the corporate tax rate is 30%. Given this data, if the firm announces that they will sell the bonds and repurchase equity what:

(a) do you expect the stock price to be immediately after the announcement?

(b) will be the firm’s total market value of equity immediately after the announcement?

(c) do you expect the stock price to be after the bond issue/repurchase are completed?

(d) will be the firm’s total market value of equity after the bond issue/repurchase are completed?

Explanation / Answer

a According to the MM proposition I (with taxes), the anticipated change in firm value deriving from this transaction is 30% x 50,000,000 = $15,000,000 (present value of the tax shield from debt). If we divide this by the number of shares outstanding at the time of the announcement, we get a price change of 15,000,000/15,000,000 = $1 per share. Thus, the price should increase up to $26.00 immediately after the announcement b Total market value of equity (immediately after the announcement): $26.00 x 15,000,000 =390,000,000 c The stock price only changes on the news of new information or on the distribution of cash to shareholders in the form of dividends. Thus, the stock price should not change at any point after the announcement. Thus, it will remain at $26 d he firm had a market value of $390,000,000 and $50,000,000 was repurchased. Thus, the market value of equity will be $390,000,000 - $50,000,000 = $340,000,000 after the transaction is complete.

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