ReelTech, a mature firm, just announced that its annual EBIT was $50 million. Gi

Question

ReelTech, a mature firm, just announced that its annual EBIT was $50 million. Given its position, we can assume that the firm cash flows will be constant to perpetuity. The corporate tax rte is 35%. The equity of ReelTech is made up of 1 million shares which now trade at a market price of $150 per share. The firm currently has no net debt, the risk-free rate is 7%, and the expected return on the market is 15%. Using this information, compute the value of the firm, the value of the equity, the cost of equity, and the cost of capital (WACC). The financial director of ReelTech estimates that the firm can increase its leverage in order to benefit from the tax-savings of debt. He intends to borrow $25 million at a cost of 7% per year. You can assume that the debt stays risk-free. The funds will be used to buy back shares on the market through a tender offer. If the firm decides to change its capital structure, compute the value of the firm, the value of the equity, the cost of equity, and the cost of capital (WACC). Determine the new price per share following this financial operation, and how many shares will be repurchased. What is the beta of equity of ReelTech before the change on the capital structure? What is the new beta of equity after the change?

Explanation / Answer

EBIT = 50000000

PAT = (1-35%)*50000000 = 32500000

Market value = 1000000*150 = 150000000 (value of the firm, the value of the equity)

Return = 32500000 / 150000000 = 21.67% (cost of equity, cost of capital (WACC) )

CAPM

21.67% = 7% + Beta*(15% - 7%)

Beta = (21.67% - 7%) / 8% = 1.83

Now borrow 25 million at 7%

Shares repurchased = 25000000 / 150 = 166666.7 shares

Wd = 25 / (25+150) = 14.29%

We = 1 - 14.29% = 85.71%

Beta = 1.83*(1+(1-35%)*(25/150)) = 2.03

Re = 7% + 2.03*(15% - 7%) = 23.24%

WACC = 14.29%*7%*(1-35%) + 85.71%*23.24% = 20.57%

New PAT = (1-35%)*(50000000 - 7%*25000000) = 31362500

market value of equity = 31362500 / 23.24% = 134950516.4

Share price = 134950516.4 / (1000000 - 166666.7) = 161.94

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