1. ABC Corp plans to announce an issue of $ 1.9 million perpetual debt, to use the proceeds for equity repurchase.
This would be a par value bond at a coupon rate of 5% (payments annually). Currently, it is an all-equity firm with $
6.7 millions of asset value, and 290,000 shares outstanding. After the issue of bonds, the firm would maintain the
new capital structure forever. Annual pre-tax earnings of $ 1.32 million are expected to remain in perpetuity. Tax
rate is 21%.
a. What is the firm’s expected return on equity before debt issue announcement?
b. Construct the firm’s market value balance sheet before announcement of debt issue.
c. What is the stock price before announcement of debt?
d. Construct the market value balance sheet immediately after the announcement of the debt issue.
e. What is the stock price after the announcement of debt?
f. How many shared are going to be repurchased after the debt issue?
g. Construct the market value balance sheet after the debt issue and restructuring.
h. What is the required return on equity after the restructuring?
Answer –
a. Expected Return on Equity Before Debt Issuance
According to Miller’s formula for return on equity (rE), it can be calculated for all-equity firm combining the
2 components:
rE = EAT / TEV
Steps:
1. Calculate EAT:
o Annual Pretax Earnings = $1.32M
o T = 21%
EAT = 1.32 × (1−0.21)
= 1.32 × 0.79
= 1.0428, M
Calculate Return on Equity:
o TEV = $6.7M
rE = 1.0428 / 6.7
= 0.1556
= 15.56 %
b. Market Value Balance Sheet Before Debt Issuance
Assets and Equity:
Explanation:
The firm is all equity before the issuance of the debt.
The MV (Market Value) of both the assets and the equity is: $6.7 million
Price Per Share:
Price per Share=Market Value of Equity / Shares Outstanding
Total Equity Value = $6.7M
Shares Outstanding = 290,000
Price per Share = 6.7 / 290,000
= 23.10 USD
c. Market Value Balance Sheet Immediately After Debt Issuance
1. New Market Value of Assets:
The firm raises $1.9M in debt, increasing its assets.
Market Value of Assets = 6.7 + 1.9
= 8.6 M
2. Liabilities and Equity:
Debt: $1.9M
Equity remains $6.7M (no immediate change until repurchase happens).
d. Stock Price Per Share After Debt Announcement
The stock price remains unchanged immediately after the announcement because no equity has been repurchased
yet.
Price per Share = Market Value of Equity / Shares Outstanding = 23.10 USD
e. Number of Shares Repurchased and Remaining Shares
1. Number of Shares Repurchased:
Explanation:
The company uses the $1.9M proceeds from the debt issuance to repurchase shares.
The repurchase price per share is the current stock price ($23.10).
Shares Repurchased = Debt Proceeds / Price per Share
Shares Repurchased = 1.923.10
= 82,239 shares
2. Remaining Shares :
Total shares outstanding = 290,000.
Remaining shares after repurchase:
Remaining Shares = 290,000 − 82,239
= 207,761
f. Market Value Balance Sheet After Restructuring
1. Assets:
Market Value of Assets =$8.6M (unchanged after repurchase).
2. Liabilities and Equity:
Debt: $1.9M
Equity: Market Value of Equity =$6.7M (same as before repurchase).
g. Required Return on Equity After Restructuring
Using Modigliani-Miller Proposition II , the required return on equity (rE ) for a leveraged firm is:
rE = rU + D/E × (rU−rD) × (1−T)
Inputs :
(rU=15.56% ) (return before debt issuance).
(D=1.9,M ) (debt issued).
(E=6.7−1.9=4.8,M) (remaining equity).
(rD=5%=0.05 ) (cost of debt).
Tax rate: (21% ).
Steps :
1. Calculate the debt-to-equity ratio (D / E):
DE = 1.94.8
= 0.3958
2. Calculate the equity return (rE ):
rE = rU + D/E × (rU−rD ) × (1−T)
Substitute values:
rE = 15.56 + 0.3958 × (15.56−5.0) × (1−0.21)
Simplify:
rE = 15.56 + 0.3958 × 10.56 × 0.79
= 15.56 + 3.31
2. A firm wants to issue 10-year 5.8% loan with gross proceeds of $ 5.3 million. Interest payments are to be
made annually with principal payment at end of loan. The floatation cost is expected to be 2.5% of gross
proceeds and will be amortized via straight line method over the loan’s life. Tax rate is 21%. a. What is the
NPV of loan excluding flotation costs? b. What is the NPV of loan including flotation costs?
Answer –
NPV of loan financing with flotation costs:
Explanation:
Borrowing provides tax benefits to the firm.
NPV of loan financing provides the net cost of borrowing.
NPV of loan financing is loan amount less present value of after-tax interest interest payments and present
value of principal repayment.
As the new issue involves flotation costs, it increases the net outflow for the company.
The NPV of flotation cost is the amount of flotation costs less the present value of the flotation cost tax
shield.
The flotation costs decrease the net benefit of borrowings.
Calculation of NPV of loan excluding flotation costs:
Loan = $5,300,000
Rate of interest = 5.8%
Period = 10 years
Tax rate = t = 21%
NPV = Loan − PV of After. − tax interest payments − PV of principal repayment
After−tax interest payments = Loan ∗ Rate of interest ∗ (1−t)
PV of after-tax interest payments:
= $5,300,000 × 5.8% × (1−0.21)
= $242,846.00
PVIFA @5.8%, 10 years = (1/r) ∗ (1−(1/(1+r)^n))
= (10.058) × (1−(1(1+0.058)^10))
= 7.43033292
PV of after − tax interest payments = After−tax interest payments ∗ PVIFA@5.8%, 10 years
= $242,846 × 7.43033292
= $1,804,426.63
PV of after-tax interest payments = $1,804,426.63
PV of principal repayment:
PV of principal repayment=Loan ∗ PVIF @5.8%, 10 years=$5,300,000×0.56904069=$3,015,915.66
PVIF @5.8%, 10 years =1/(1+r)n)=1(1+0.058)10=0.56904069
NPV of loan financing=Loan − PV of after−tax interest payments − PV of loan repayment=$5,300,000−
$1,804,426.63−$3,015,915.66=$479,657.71
Answer a: NPV of loan financing excluding flotation costs = $479,657.71
Explanation:
As interest payments are tax deductible, taking a loan is beneficial.
Calculation of NPV of loan excluding flotation costs:
Loan = $5,300,000
Flotation costs = 2.5% of loan
Rate of interest = 5.8%
Period = 10 years
Flotation costs=Loan ∗2.5%=$5,300,000×2.5%=$132,500
Tax rate = t = 21%
Flotation cost written off each year=Flotation costs/life=$132,50010=$13,250
After−tax flotation cost written off each year=Flotation costs written off each year∗t=$13,250×21%=$2,782.
50
PVIFA @5.8%, 10 years [Step 2] = 7.43033292
PV of flotation costs=Flotation costs−PV of flotation costs written off eachyear
PV of flotation costs =Flotation costs − PV of flotation costs written off each year=$132,500−
$2,782.50×7.43033292=$111,825.10
PV of flotation costs = $111,825.10
NPV of loan with flotation costs:
NPV =NPV of loan excluding flotation costs − PV of flotation costs=$479,657.71−$111,825.10=$367,832.61
Answer b: NPV of loan including flotation costs = $367,832.61
Explanation:
As flotation costs are outflows, it decreases the net advantage available due to loan financing.
[Link] wants to acquire BCD. Both firms are unlevered. ACS believes that the acquisition would increase total after
tax annual cash flow by $ 1.45 million indefinitely. Current market value of BCD is $ 31.5 million, and that of ACS is
$ 53 million. The discounting rate is 10%. ACS is trying to decide whether it must offer 40% of its stock or $ 44.5
million in cash to acquire BCD. a. What is the cost of each alternative? b. What is the NPV of each alternative? c.
What is the best alternative – cash or stock?
Answer –
Given Information:
Annual increase in after-tax cash flow due to the acquisition: $1.45 million (per year indefinitely).
Discount rate =10% (0.10 as a decimal)
Market value of BCD =$31.5 million
Market value of ACS =$53 million
Two alternatives for the acquisition of BCD:
Offer 40% of ACS's stock.
Offer $44.5 million in cash.
a. Cost of Each Alternative
1st step:
The market value calculation method determines the acquisition costs through either assessment of stock
offers percentages or the monetary cash proposals.
We need to calculate the cost of each alternative for acquiring BCD.
1. Stock Offer:
ACS plans to offer 40% of its stock in exchange for BCD. Knowing that the current market value of ACS is $53
million provides us the rate of 40% of ACS stock:
Stock Offer = 0.40 × 53 million = 21.2 million
Thus, the cost of the stock offer is $21.2 million.
2. Cash Offer:
Now looking from the cash perspective, ACS can offer $44.5 million to get BCD:
Thus, the cost of the cash offer is $44.5 million.
b. NPV of Each Alternative
1st step:
The evaluation process for alternative profitability uses Net Present Value (NPV) to determine profits
through present value calculations of cash flow and acquisition costs.
In order to find the NPV of each alternative, we must determine how much future cash inflows from the
acquisition would be valued in today's dollars. Given that the increase in cash inflows is expected to
continue for perpetuity, the present value can be determined using the perpetuity formula.
Perpetuity Formula:
The present value of an infinite series of cash flows (perpetuity) is defined mathematically as:
Present Value of Cash Flows = Annual Cash Flow / Discount Rate
Where:
Annual Cash Flow = $1.45 million (the increase in after tax annual cashflow).
Discount Rate = 10% (0.10 as a decimal).
Let’s compute the present value of the cashflow increase.
PV of Cash Flows = 1.45 million / 0.10 = 14.5 million
This is to say that the acquisition will yield an increase in value of $14.5 million for ACS.
1. NPV of Stock Offer:
n the first scenario, ACS is relinquishing 40% of its stock to the new investors which is equivalent to $21.2
million. The NPV of the Stock Offer is determined by estimating the value increase in cash flow and
determining the present cash value in this case, and then subtracting it from the expense incurred offering
the stock (which is simply the cost valued in dollars):
NPV (Stock Offer) = PV of Cash Flows − Stock Offer Cost
= 14.5million − 21.2 million
= −6.7
NPV (Stock Offer) = −6.7 million
Thus, the NPV of the stock offer is -6.7 million.
2. NPV of Cash Offer:
Looking at the Cash scenario, ACS will execute Cash transaction for BCD at 44.5 million''. The NPV of Cash
Offer is estimated by taking the cash flow increment and its present value subtracting it with the cash
outlay:
NPV (Cash Offer) = PV of Cash Flows − Cash Offer Cost
= 14.5 million − 44.5 million
= −30
NPV (Cash Offer) = −30 million
Thus, the NPV of the cash offer is -30 million.
c. Best Alternative – Cash or Stock?
1st step:
The comparison between NPVs helps select the best option through the evaluation of the alternative with
the least negative result.
Even alternative approaches still provide us with negative NPVs. In either approach, the conclusion would
be:
NPV of Stock Offer: -6.7 million
NPV of Cash Offer: -30 million
The common objective in both NPVs is that loss is greater which means ACS incurs a larger loss and to
mitigate that loss the value of NPV must be optimal leading to lower cost when selected.
The stock offer results in a smaller negative NPV of -6.7 million compared to the cash offer of -30
million.
So, the best alternative is the stock offer since it provides a favorable lower expenditure for ACS.