In Sept. 2008, the U.S. government seized control of AIG in exchange for $85 bil

Question

In Sept. 2008, the U.S. government seized control of AIG in exchange for $85 billion. Later, the company was given $95 billion more. The justification for the bailout was not just to save AIG, but also to save the financial system - or so it was alleged.

After AIG received its bailout funds, the company started a massive restructuring project by selling many business units to pay off its debt.

AIG after the crises

It is now December 2012 and the business has stabilized. The amount of debt on AIG’s balance sheet is now $10 billion on which AIG pays an interest rate of 7% per year. AIG has $500 million in excess cash remaining from its sale of assets over the previous several years.

AIG’s stock price is $30 per share (on December 31, 2012). AIG has 1.5 billion common shares outstanding. The company’s marginal tax rate is 40%.

a. What is the value of AIG as an unlevered firm (Vu) as of now (i.e., the end of 2012). Please show your analysis.

b. Assume that AIG announces that it will use $500 million of excess cash to retire equity. What will be the share price be just after the announcement?

c. Assume AIG keeps the $500 million excess cash in the firm. Instead AIG announces that it will borrow $1 billion debt to repurchase equity. What will be the share price just after the announcement?

Explanation / Answer

(a) Unlevered firm is one which has no leverage (financing or debt obligation) and is considered to be entirely equity financed. This implies that in the Asset - Liability equation given below :

Asset = Shareholder's Equity + Liabilities, the liability part is zero and the entire asset of the firm comprises of the shareholder's equity. (which can be assumed to be only common stock held by shareholder's with no preferred stock, convertible stock)

If the entire asset is comprised of shareholder's equity then the firm value should also be equal to the shareholder's equity. Therefore, Unlevered Firm value of AIG = Shareholder's Equity Value

Current Stock Price = $ 30 per share and Number of Shares outstanding = 1500 million or 1.5 billion

Therefore, Shareholder's Equity Value = Current Stock Price X Number of Shares outstanding = $ 30 x 1500 = $ 45000 million OR $ 45 Billion.

Therefore, unlevered firm value = $ 45 billion (this is also known as the firm's market capitalization value)

(b) In order to calculate the new stock price post repurchase announcement we need to look at the "intrinsic value" of equity per common stock outstanding post repurchase.

Intrinsic Value of Firm (Enterprise Value) Calculation:

Market Capitalization = $ 45 billion (from part a)

Debt Value = $ 10 billion and Cash Reserves = $ 0.5 billion

Therefore, Enterprise Value = Market Capitalization + Debt Value - Cash = 45 + 10 - 0.5 = $ 54.5 billion

Now calculating the intrinsic equity or common stock value will involve:

Subracting debt from enterprise value

Adding back cash

Also, post repurchase the adding back cash part will not have any cash to add back as all the cash would have been used in share repurchase (retiring equity). So one will just need to subtract the debt value from the enterprise value or intrinsic value.

Now, repurchase amount = $ 0.5 billion and common stock price = $ 30

Therefore, number of common stock purchased = Repurchase Amount / Stock Price = 500 / 30 = 16.67 million

Therefore, number of common stock remaining = 1500 - 16.67 = 1483.33 million

Enterprise Value = $ 54.5 billion

Equity Value (Intrinsic) = Enterprise Value - Debt Obligation + Cash = 54.5 -10 + 0 = $44.5 billion

Therefore, Share Price post repurchase = Intrinsic Equity Value / Common Stock Remaining = 44.5 / 1.4833 = $ 30.0067 (which is infact close to the earlier price as any lowering of equity value also lowers the number of outstanding shares)

(c) If the firm uses a debt to repurchase shares then the company cash reserves stay intact.

In such a scenario,

New Enterprise Value = Old Enterprise Value + New Debt Obligation = 45 + 10 - 0.5 + 1 = $ 55.5 billion

New Equity Value = New Enterprise Value - Total Debt Obligation + Cash = 55.5 - 11 + 0.5 = $ 45 billion

Number of Outstanding Shares Remaining = 1.5 billion - amount repurchased = 1.5 - (Repurchase Value / Current Stock Price) = 1.5 - ( 1 billion / 30) = 1.4666 billion

Therefore, stock price post repurchase = New Equity Value / Outstanding Stock Remaining = 45 / 1.466 = $ 30.69

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