Repurchase Stock
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Green Manufacturing, Inc., plans to announce that it will issue $2 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will have a 6-percent annual coupon rate. Green is currently an all-equity firm worth $10 million with 500,000 shares of common stock outstanding. After the sale of the bonds, Green will maintain the new capital structure indefinitely. Green currently generates annual pretax earnings of $1.5 million. This level of earnings is expected to remain constant in perpetuity. Green is subject to a corporate tax rate of 40 percent.
1.What is the expected return on Green's equity before the announcement of the debt issue?
2.Construct Green's market-value balance sheet before the announcement of the debt issue. What is the price per share of the firm's equity?
3.Construct Green's market-value balance sheet immediately after the announcement of the debt issue.
4.What is Green's stock price per share immediately after the repurchase announcement?
5.How many shares will Green repurchase as a result of the debt issue? How many shares of common stock will remain after the repurchase?
6.Construct the market-value balance sheet after the restructuring. What is Green's stock price per share after the restructuring?
7.What is the required return on Green's equity after the restructuring?
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Solution Summary
The solution explains the impact on the balance sheet of issuing debt and repurchasing stock.
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1. The expected return on a firm's equity is the ratio of annual after-tax earnings to the market value of the firm's equity.
Green expects $1,500,000 of pre-tax earnings per year. Because the firm is subject to a corporate tax rate of 40%, it must pay $600,000 worth of taxes every year. Since the firm has no debt in its capital structure and makes no interest payments, Green's annual after-tax expected earnings are $900,000 (= $1,500,000 - $600,000).
The market value of Green's equity is $10,000,000.
Therefore, the expected return on Green's unlevered equity is 9% (= $900,000 / $10,000,000).
Notice that perpetual annual earnings of $900,000, discounted at 9%, yields a market value of the firm's equity of $10,000,000 (= $900,000 / 0.09).
2. Green is an all-equity firm. The present value of the firm's after-tax earnings is $10,000,000 {= ($1,500,000 - $600,000) / 0.09}.
Green's market-value balance sheet before the announcement of the debt issue is:
Since the market value of Green's equity is $10,000,000 and the firm has 500,000 shares of common stock outstanding, the price of Green's stock is $20 per share (= $10,000,000 / 500,000 shares) before the announcement of the debt issue.
3. Modigliani-Miller Proposition I states that in a ...
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