Upon announcement the equitys value increases to 920m

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Upon announcement, the equity’s value increases to $920M and thus the share price is: $920M / 100M = $9.2 You can repurchase $500M / $9.2 = 54.35M shares After the recap, there are 100M – 54.35M = 45.65M shares. E(EPS) = ($60M – .02 × $500M) × (1 – .4) / 45.65M = $.66 And the share price is E(EPS) / r E = $.66 / 7.143% = $9.2 Bottom line: Shareholders capture the benefit of the tax shield! After the recap firm value, share prices, EPS, and the cost of equity increase, but WACC decreases. Lecture 5: MM Propositions
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Reality Check This model implies that we should see all firms have 99.99 % leverage? Do we really see that in reality? o NO! Most firms have debt ratios far below 100%. So, the M&M with taxes is not a realistic model – something is missing To think about what is missing, think about the 99% debt financed firm. M&M assumes that corporate debt is risk-free. Do you think that the bonds of that firm are indeed risk-free? What is the probability that this firm goes bankrupt? Are you willing to lend it money at the risk-free rate (i.e. at the rate that you lend money to the US Treasury)? NO! So, what s missing is bankruptcy costs (i.e. risky debt). Lecture 5: MM Propositions 49
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We learnt ü with perfect capital markets, changing capital structure does not affect total firm value or the firm’s WACC (MM without taxes). ü with corporate taxes, firm value is increasing and WACC is decreasing in the amount of debt (MM with taxes). Shareholders capture the benefit of increases in debt. ü both with and without corporate taxes, MM2 implies that: - Leverage increases expected EPS but also its volatility. - Leverage increases the required return on equity ü with taxes only, very large amounts of debt appear to be optimal, provided that you have taxable income .But we don’t see this in practice... Lecture 5: MM Propositions 50
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Christopher Reinemann
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