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Recapitalization and Value of Operations

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1. Michaely Inc. is an all-equity firm with 200,000 shares outstanding. It has $2,000,000 of EBIT, which is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per shares (DPS). Its tax rate is 40%.

The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase stock. The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the recapitalization occurs.

Calculate the number of shares to be repurchased. Assuming that the shares can be repurchased at the price that existed prior to the recapitalization, what would be the share price following the recapitalization?

2. Vasudevan Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 13% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the Year 0 value of operations, in millions?

Year: 1 2 3
Free cash flow: -$20 $42 $45

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Solution Preview

See attached Excel file for calculations.

The increase in share price after recapitalization is expected inasmuch as the firm has additional funds without ...

Solution Summary

Using an Excel 97-2003 spreadsheet, this solution addresses two problems. First, it illustrates how to compute the number of shares repurchased in a recapitalization and their expected market values. It then computes the value of operations of a firm, including its terminal value.

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Capital structure: Expected stock price after recapitalization. Given these assumptions, what would be the expected year-end stock price if the company proceeded with the recapitalization?

Etchabarren Electronics has made the following forecast for the upcoming year based on the company's current capitalization:

Interest expense $2,000,000
Operating income (EBIT) $20,000,000
Earnings per share $3.60

The company has $20 million worth of debt outstanding and all of its debt yields 10 percent. The company's tax rate is 40 percent. The company's price earnings ratio has traditionally equaled 12, so the company forecasts that under the current capitalization its stock price will be $43.20 at year end.

The company's investment bankers have suggested that the company do a recapitalization. Their suggestion is to issue enough new bonds at a yield of 10 percent to repurchase 1 million shares of common stock. Assume that the stock can be repurchased at today's $40 stock price.

Assume that the repurchase will have no effect on the company's operating income; however, the repurchase will increase the company's dollar interest expense. Also, assume that as a result of the increased financial risk the company's price earnings ratio will be 11.5 after the repurchase. Given these assumptions, what would be the expected year-end stock price if the company proceeded with the recapitalization?

a. $48.30
b. $42.56
c. $44.76
d. $40.34
e. $46.90

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