Problem 1: A consultant has collected the following information regarding Young Publishing:
Total assets $3,000 million Tax rate 40%
Operating income (EBIT) $800 million Debt ratio 0%
Interest expense $0 million WACC 10%
Net income $480 million M/B ratio 1.00×
Share price $32.00 EPS = DPS $3.20
The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). Young’s stock price can be calculated by simply dividing earnings per share by the required return on equity capital, which currently equals the WACC because the company has no debt.
The consultant believes that the company would be much better off if it were to change its capital structure to 40 percent debt and 60 percent equity. After meeting with investment bankers, the consultant concludes that the company could issue $1,200 million of debt at a before-tax cost of 7 percent, leaving the company with interest expense of $84 million. The $1,200 million raised from the debt issue would be used to repurchase stock at $32 per share. The repurchase will have no effect on the firm’s EBIT; however, after the repurchase, the cost of equity will increase to 11 percent. If the firm follows the consultant’s advice, what will be its estimated stock price after the capital structure change?
Problem 2: A growing company is confronted with a choice between 15% debt issues and equity issues to finance its new investments. The firm’s pre-expansion income statement is as follows:
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Sales (production capacity of $6,000,000 at current sales price)
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4,500,000
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Fixed cost
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500,000
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Variable cost (66 2/3%)
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3,000,000
|
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EBIT
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1,000,000
|
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Interest at 12.5%
|
100,000
|
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Earnings before taxes
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900,000
|
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Income tax (at 50%)
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450,000
|
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Net income
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450,000
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Earnings per share (EPS)
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9
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The expansion programme is estimated to cost $500,000. If this is financed through debt, the rate on new debt will be 15% and the P/E ratio will be 10 times. If expansion programme is financed through equity, new shares can be sold at $100 per share, and the P/E ratio will be 12 times. Expansion will generate additional sales of $1,275,000. No additional fixed costs would be needed to meet the expansion operation. If the company is to follow a policy of maximising the market value of its shares, which form of financing should be employed by the company?