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Mohammad Ali
Mohammad Ali, Accounts & Financial Advisor
Category: Finance
Satisfied Customers: 370
Experience:  Qualified Cost & Management Accountant, with 2 years experience in Financial & Audit Services
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The All-Star Production Corporation (APC) is considering a

Resolved Question:

The All-Star Production Corporation (APC) is considering a recapitalization plan that would convert APC from its current all-equity capital structure to one including some financial leverage. APC now has 10,000,000 shares of common stock outstanding, which are selling for $40.00 each, and you expect the firm’s EBIT to be $50,000,000 per year, for the foreseeable future. The recapitalization proposal is to issue $100,000,000 worth of long-term debt, at an interest rate of 6.50 percent, and use the proceeds to repurchase as many shares as possible, at a price of $40.00 per share. Assume there are no market frictions such as corporate or personal income taxes. Calculate the expected return on equity for APC shareholders under both the current all-equity capital structure and under the recapitalization plan.
a. Calculate the number of shares outstanding, the per-share price, and the debt-to-equity ratio for APC if the proposed recapitalization is adopted.

b. Calculate the earnings per share (EPS) and the return on equity for APC shareholders, under both the current all-equity capitalization and the proposed mixed debt/equity capital structure.
Submitted: 7 years ago.
Category: Finance
Expert:  Mohammad Ali replied 7 years ago.

We will first carry out a tabular comparison of the two capital structures and then do the commentary:

 

All equity

Debt/ Equity mix

Earnings before interest and tax

$50,000,000

$50,000,000

Less interest

0

$6,500,000

Earnings after interest

50,000,000

43,500,000

Less tax

0

0

Earnings after tax (a)

$50,000,000

$43,500,000

 

 

 

Number of ordinary shares outstanding (b)

10,000,000

7,500,000 (see working 1 below)

Earnings per share a/b

$5 per share

$5.8 per share

Value of debt (c)

0

$100,000,000

Value of equity (d)

$400,000,000

$348,000,000(see working 3 below)

Return on equity (a/d)*100

12.5%

14.36%

Share Price

$40

$46.4 (see working 2 below)

Debt to equity ratio (c/d)*100

0%

33.33%

 

Working 1:

Number of ordinary share before debt issue = 10,000,000

Value of debt issued= $100,000,000

Number of shares bought back= 1000,000,000/40

=2,500,000 shares

So the number of shares left outstanding= 10,000,000-2,500,000

=7,500,000 shares

Working 2:

The firm's current price/ earnings ratio is 8 ($40/$5 per share). If this P/E remains the same, then the new price of the share will be 8* the new EPS, that is 8*5.8, which gives us a price of $46.4 per share.

Working 3:

Since we have 7.5 million shares outstanding, and the price of one share is now $46.8, the value of equity is =7,500,000*46.8

=$348,000,000

from this, it can be seen that issuing debt will certainly increase the value of the firm and improve its return on equity, but it will also increase its debt gearing levels.

 

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