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George Company: Compute expected return on equity, debt-equity ratio, buyback

Problem #1

We follow the performance of the George Company with a stock that's trading for $14/share. They have 1MM outstanding shares and has $6MM in outstanding debt that yields 10% per annum. They have an EBIT of $4MM that will remain constant forever. The tax rate is 40%.

1. What is the expected return on equity before the buyback?

2. What is the new debt-equity ratio after the buyback?

3. What is the expected return on equity after the buyback?

Problem #2

Based on the information provided, decide which of the two companies should have more debt as a fraction of the market value of the firm. Briefly describe the relevant factors in the decision.

Case A Company 1 Company 2
Book value of assets $2 billion $1 billion
Market value of equity $7 billion $500 million
Growth in earnings 19% 1%
Capital Expenditures $200 million $13 million

Case B Company 3 Company 4
Standard deviation of the 35% 60%
Annual change in operating
income

Solution Preview

First Problem:

1. What is the expected return on equity before the buyback?
The EBIT is $4.0 million, if we subtract the interest (10% of $6million) $0.6 million we get 3.4 million. As the tax rate is 40% we get tax (40% of 3.4 million) = 1.36million that gives us the expected return on equity before buyback of 2.04 million. If we calculate the expected return on equity per share we get 2.04 million divided by 1million (the number of equity shares) = $2.04.

2. What is the new debt-equity ratio after the buyback?
Since the price of the share in the market is $14 per share the after tax income of $2.04 million can only buy (2.04million divided by 14) = 0.146 million shares. If we subtract this from the total number of shares that is 1million, we get the shares outstanding after buyback 0.854 million. The debt remains stable at $6 million so we have a new debt- equity ratio of 6/0.854 = 7.025.

3. What is the expected return on equity after the buyback?
Since the company has an EBIT of $4 ...

Solution Summary

In a 744 word solution, the response presents clear discussion of the questions of analyze and ratios for George Company.

$2.19