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Capital Structure and Leverage - Solutions8

# Capital Structure and Leverage - Solutions8 - Amount...

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 37 of 59 Pages Amount Borrowed Cost of Debt Equity Beta Cost of Equity \$0 0.0% 1.60 16.00% \$10,000 12.0% 1.80 17.00% \$20,000 14.0% 2.00 18.00% \$30,000 16.0% 2.40 20.00% \$40,000 18.0% 2.95 22.75% \$50,000 20.0% 3.80 27.00% Assuming that the firm pays out all earnings to its shareholders (EPS = DPS and g = 0%), you should be able to determine the current price of the firm’s stock. Now assume that the firm intends to issue \$20,000 of debt and use the proceeds to repurchase shares of stock. Also assume that the market does not anticipate the new stock price and that stockholders sell their shares back at the current price. Eventually (after the firm actually issues the debt and repurchases shares), the market will realize their mistake and a new equilibrium price will be achieved. Determine by how much this new equilibrium price will exceed the current/original price. A. \$1.65 B. \$2.16 C. \$1.82 * D. \$2.33 E. \$1.99 Current EPS = \$10,800 / 2,500 = \$4.32 Current Price = \$4.32 / .16 = \$27.00 Shares repurchased = \$20,000 / \$27.00 = 740.74 Remaining shares = 2,500 - 740.74 = 1,759.26 New Income Statement: Income Statement Starting Values Sales \$100,000 Fixed Costs -\$20,000 Variable Costs -\$60,000 EBIT \$20,000 Interest -\$2,800 EBT \$17,200 Taxes (46%) -\$7,912 Net Income \$9,288

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 38 of 59 Pages New EPS = \$9,288 / 1,759.26 = \$5.28 New Price = \$5.28 / .18 = \$29.33 Increase in Price = \$29.33 - \$27.00 = \$2.33 39. Assume that your company is an all-equity firm with 250,000 shares outstanding. The company’s EBIT is \$2,500,000, and EBIT is expected to remain constant over time. The company pays out all of its earnings each year, so its earnings per share are equal to its dividends per share and this is currently \$6.00 per share. The company’s tax rate is 40 percent, its current cost of stock, K S , is 8 percent, and its current stock price is \$75 per share. Now assume that the company is considering issuing \$3.75 million worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated yield to maturity of 5 percent or interest of \$187,500. The risk-free rate in the economy is 4 percent, and the market risk premium is 5 percent. The company’s beta is currently 0.8, but its investment bankers estimate that the company’s beta would rise to 0.9 if it proceeds with the recapitalization. Assume that the shares are repurchased at a price equal to the stock market price prior to the recapitalization (that is, the market does not anticipate any change in price). Given this information, determine the price of the company’s stock after the recapitalization has been completed. A. \$80.29 * B. \$81.62 C. \$76.43 D. \$83.08 E. \$78.81 First, find the company’s current cost of capital, dividends per share, and stock price: K s = 0.04 + (0.05)(0.8) = 8.0% DPS = (\$2,500,000)(1 - 0.4) / (250,000) = \$6.00 P 0 = \$6.00 / 0.08 = \$75.00 Alternatively, Value = (\$2,500,000)(1 - 0.4) / 0.08 = \$18,750,000 P 0 = \$18,750,000 / 250,000 = \$75.00 Therefore, Shares repurchased = \$3,750,000 / \$75 = 50,000
Old Exam Questions - Capital Structure and Leverage - Solutions Page 39 of 59 Pages New shares outstanding = 250,000 - 50,000 = 200,000 New K S = 0.04 + (0.05)(.9) = 8.5%

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Capital Structure and Leverage - Solutions8 - Amount...

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