Brother, Inc. is planning to repurchase part of its common stock by issuing corp

Question

Brother, Inc. is planning to repurchase part of its common stock by issuing corporate
debt. Therefore, its debt-equity ratio is expected to rise from 30% to 60%. The firm currently has 4.5 million worth of debt outstanding. The cost of this debt is 10% per year. Brother, Inc. expects to have a Free Cash Flow of $2.56 million per year in perpetuity and it pays no taxes.
a. What is the market value of Brother, Inc. before and after the repurchase announcement?
b. If Brother, Inc’s expected return on the firm’s equity before the stock repurchase plan is 14.07%, what is the expected return on the firm’s equity of an otherwise identical all-equity firm?
c. What is the expected return on the Brother Inc’s equity after the announcement of the stock repurchase plan?

PS: Show your work please.

Explanation / Answer

Before Repurchase:

Given debt to equity is 30% i.e 0.3 that 30% represents 4.5 millions

that means equity would be 4.5/0.3 = 15 millions

Total market value = 15+4.5 = 19.5 million dollars

After repurchase:

If the company repurchases common stock by issuing a corporate debt.Let the part of common stock be X

that means it will purchase commonstock by issuing same part of debt

(4.5+X)/(15-X) = 0.6

4.5 + X = 9-0.6X

1.6X = 9-4.5

X =2.8125 new debt will be 4.5+2.8125 = $7.3125 millions

New equity will be 15-2.8125 =12.1875

Market value will be = 7.3125+12.1875 = $19.5 millions

B)If it is all equity firm; the expected return on firms equity will be = 2.56/19.5 =13.28%

C)free cash flow = $2.56 millions

Less: interest expense @ 10% = 7.3125*0.1 =0.73125 millions

Return on equity after the announcement of stock repurchase plan = (2.56-0.73125)/12.1875 =15.05%

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