Union brick inc. has a total market value of $200 million, consisting of 2 milli
ID: 2786554 • Letter: U
Question
Union brick inc. has a total market value of $200 million, consisting of 2 million shares of common stock selling for $50 per share and $100 million of 10% perpetual bonds currently selling at par. UBI pays out all earnings as dividends, and its marginal tax rate is 40%. The firm’s earnings before interest and taxes (EBIT) are $30 million. Management is considering increasing UBI’s debt to $140 million by calling in all the old bonds and issuing new debt with a 12% coupon which sells at par. The additional funds will be used to repurchase stock at the new equilibrium price. If UBI’s financial leverage is increased as described, the required rate of return on common equity will increase to 15%
a) What is UBI’s current required rate of return on equity?
b) What would be the value of the firm in the capital structure change were made?
c) Regardless of your answer to the previous question, assume the value of the firm would be $204 million if the capital structure change were made. What would be the new stock price?
Explanation / Answer
ans(a)
present capital structure:
2m equity shares @$50 per share= $100m
10% bonds $100m
total $200m
present income statement
EBIT 30
less interest 10
EBT 20
less tax 40% 8
EAT (equity earnings) 12
return on equity = equity earnings/ Market value of equity = 12/100= 0.12 or 12%
ans (b)
new capital structure:
equity $60m ($40m is repurchased using additional funds)
debt 12% $140m
total $200m
Income statement
EBIT $30m
less interest 16.8 ( 12% 0n 140)
EBT 13.2
less tax @40% 5.28
EAT 7.92
return on equity= equity earnings/ market value of equity
0.15= 7.92/Market value of equity
Market value of equity= 7.92/0.15= $52.8m
value of firm= value of equity + value of debt= 52.8 + 140=$198.2m
ans (c)
value of firm = value of debt + value of equity
204= 140 + value of equity
value of equity = $64m
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