Section _6--Bullseye

# Section _6--Bullseye - Section #6 Capital Structure Case...

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Section #6 “Capital Structure Case Analysis: The Bullseye Corporation” October 14th, 2010 Copyright 2010 by Rich Curtis

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The Bullseye Corporation
A. Valuing The Common Stock Of The Unlevered Firm (See “Bullseye” Case, pp. 1-2) 1. Assume that the Bullseye Corporation currently has no debt but has 1,000,000 shares of common stock outstanding. The corporate tax rate is 35%. Each year, all the corporation’s after-tax earnings are paid to the common stockholders as a cash dividend. The cash dividends are paid annually with the next cash dividend being paid one year from today. Also assume that EBIT = \$15,384,615.38 each year, Net Income = (1-t c )(\$15,384,615.38) = (1-.35)(\$15,384,615.38) = \$10,000,000 each year, and k e (0) = the after-tax cost of equity of the unlevered firm = .20

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2. Then the total market value of the unlevered firm equals the market value of the common stock since there is no debt outstanding. 3. Questions : What is the total market value of the common stock of the the Bullseye Corporation and what is the price per share?
Answers : Total Equity Value = Dividend k e (0) = \$10,000,000 .20 = \$50,000,000 Net Income P S = \$50,000,000 1,000,000 shares = \$50/share

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B. Substitute \$40,000,000 Of Debt For The Common Stock Equity (See “Bullseye” Case, pp. 3-6) 4. Now assume that the Bullseye Corporation issues \$40,000,000 of perpetual debt and pays the proceeds to the common stockholders as a common stock cash dividend. The cash dividend will therefore be \$40 per share. The assets of the firm will be unchanged since the cash raised is immediately paid out.
5. The market value of the levered firm, V L , is given by the following expression: V L = V U + t c B = \$50,000,000 + (.35)(\$40,000,000) = \$64,000,000. The overall value of the firm has increased because the debt shields some EBIT from taxes. More of EBIT goes to investors in the firm’s securities--less goes to the Internal Revenue Service.

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6. Since the market value of the levered firm, V L , equals the market value of the bonds outstanding plus the market value of the common stock outstanding, one can solve for the market value of the outstanding common stock. Questions : What is the total market value of the outstanding common stock of “The Bullseye Corporation” after the \$40 million bond issuance and the payment of the \$40 million cash dividend? What is the new common stock price per share?
Answers : S L = V L B L = \$64,000,000 \$40,000,000 = \$24,000,000 P S = \$24,000,000 1,000,000 shares = \$24/share

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Let’s look at the annual tax savings and also the dividends received by the stockholders to see if our results are consistent with a cash flow analysis. (I hope they are or my intuition is messed up!!)
EBIT = \$15,384,615.38 Interest @ 8% = \$3,200,000.00 (8% is Assumed) Taxable Income = \$12,184,615.38 Tax @ 35% = \$4,264,615.38 Net Income = \$7,920,000.00 = Annual Dividend Note : The annual tax saving is: \$5,384,615.38 - \$4,264,615.38 = \$1,120,000 Discounting the annual tax savings “perpetuity”

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## This note was uploaded on 09/24/2011 for the course HADM 2225 taught by Professor Wellman, j during the Spring '08 term at Cornell.

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Section _6--Bullseye - Section #6 Capital Structure Case...

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