Purchase Solution

# Repurchase Stock

Not what you're looking for?

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?

##### Solution Summary

The solution explains the impact on the balance sheet of issuing debt and repurchasing stock.

##### Solution Preview

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 ...

##### Understanding Management

This quiz will help you understand the dimensions of employee diversity as well as how to manage a culturally diverse workforce.