Explore BrainMass
Share

Explore BrainMass

    Recapitalization

    This content was COPIED from BrainMass.com - View the original, and get the already-completed solution here!

    1. Firms A and B are identical except for their level of debt and the interest rates they pay on debt. Each has $2 million in assets, $400,000 of EBIT, and has a 40% tax rate. However, firm A has a debt-to-assets ratio of 50% and pays 12% interest on its debt, while Firm B has a 30% debt ratio and pays only 10% interest on its debt. What is the difference between the two firms' ROEs?

    1.25%
    1.91%
    2.23%
    2.64%
    2.86%

    2. The firm's target capital structure is consistent with which of the following?

    Maximum earnings per share (EPS).
    Minimum cost of debt (rd).
    Highest bond rating.
    Minimum cost of equity (rs).
    Minimum weighted average cost of capital (WACC).

    3. Jones Co. currently is 100% equity financed. The company is considering changing its capital structure. More specifically, Jones' CFO is considering a recapitalization plan in which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock. The recapitalization would not change the company's total assets nor would it affect the company's basic earning power, which is currently 15%. The CFO estimates that the recapitalization will reduce the company's WACC and increase its stock price. Which of the following is also likely to occur if the company goes ahead with the planned recapitalization?

    The company's net income will increase.
    The company's earnings per share will decrease.
    The company's cost of equity will increase.
    The company's ROA will increase.
    The company's ROE will decrease.

    4. Tapley Inc. currently has assets of $5 million, zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $1 million, and pays out 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 5 percent per year, 200,000 shares of stock are outstanding, and the current WACC is 13.40%.The company is considering a recapitalization where it will issue $1 million in debt and use the proceeds to repurchase stock. Investment bankers have estimated that if the company goes through with the recapitalization, its before-tax cost of debt will be 11%, and its cost of equity will rise to 14.5%.

    What is the stock's current price per share (before the recapitalization)?

    Assuming the company maintains the same payout ratio, what will be its stock price following the recapitalization?

    © BrainMass Inc. brainmass.com October 9, 2019, 9:51 pm ad1c9bdddf
    https://brainmass.com/business/finance/recapitalization-199659

    Solution Preview

    Please see the attached file for answers/explanations in blue

    1. Firms A and B are identical except for their level of debt and the interest rates they pay on debt. Each has $2 million in assets, $400,000 of EBIT, and has a 40% tax rate. However, firm A has a debt-to-assets ratio of 50% and pays 12% interest on its debt, while Firm B has a 30% debt ratio and pays only 10% interest on its debt. What is the difference between the two firms' ROEs?

    1.25%
    1.91%
    2.23% X
    2.64%
    2.86%

    A B
    Total assets 2,000,000 2,000,000
    Debt 1,000,000 600,000
    EBIT 400,000 400,000
    Interest 120,000 60,000
    EBT 280,000 340,000
    Tax (40%) 112,000 136,000
    Net Income 168,000 204,000
    Equity 1,000,000 1,400,000
    ROE 16.8% 14.57%
    Difference 2.23%

    2. The firm's target capital structure is consistent with which of the following?

    Maximum earnings per share (EPS).
    Minimum cost of debt (rd).
    Highest bond rating.
    Minimum cost of equity (rs).
    Minimum weighted average cost of capital (WACC). X

    This is ...

    Solution Summary

    The solution has various questions relating to recapitalization

    $2.19