Case Scenario:
Strom, Inc., is an all-equity firm with 250,000 shares of common stock outstanding. Each share is worth $20. The firm pays no taxes. The appropriate discount rate for the firm's unlevered equity is 15 percent. Strom's earnings last year were $750,000, and management expects that the firm's earnings will remain at $750,000 per annum into perpetuity.
Strom is planning to buy a competitor's business for $300,000. Once acquired, the competitor's facilities are expected to increase Strom's earnings by $120,000 per year. The competitor is also an all-equity firm with the same risks as Strom and a required return on its equity of 15 percent.
A. Construct the market-value balance sheet for Strom before the announcement of the buyout is made.
B. Suppose Strom decides to issue equity in order to fund the buyout.
1. According to the efficient-market hypothesis, what will Strom's stock price be immediately after the announcement?
2. Construct Strom's market-value balance sheet immediately after the announcement.
3. How many shares will Strom need to issue in order to fund the buyout?
4. Construct Strom's market-value balance sheet after the equity issue but before the purchase is finalized.
5. Construct Strom's market-value balance sheet after the purchase is finalized.
6. What is the expected return to Strom's equityholders after the buyout?
7. What is Strom's weighted average cost of capital after the buyout?
C. Suppose Strom decides to issue 10 percent debt in order to fund the buyout.
1. Construct Strom's market-value balance sheet immediately after the announcement.
2. Construct Strom's market-value balance sheet after the debt issue but before the purchase is finalized.
3. Construct Strom's market-value balance sheet after the purchase is finalized.
4. What is the expected return to Strom's equityholders after the buyout?
5. What is Strom's weighted average cost of capital after the buyout?