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Determine the value of the firm before the debt-equity swap

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Raymond Manufacturing is a privately held company; all long-term finances are from the Raymond brothers in the form of equity interests. An aggregate of 1 million shares is distributed between the Raymond brothers: Roy has a 50% equity interest in the firm and Bon has the other 50% equity interest.
The firm is expected to generate annual earnings stream (EBIT) in the amount of $3.692 million per annum in perpetuity. The estimated beta for the company is 1.923 (?0). The firm pays a 35% corporate tax rate.

The firm intends to conduct a debt-equity swap by raising 4.731 million in debt and using the proceeds to retire a portion of the existing equity interest held by the brothers. This additional borrowing is in the form of a syndicated loan from a group of commercial banks. The effective interest rate on this syndicated loan (rb) is 10% per annum. For ease of calculation, we shall assume a perpetual loan. That is, we assume the firm can indefinitely restructure this loan at the same market interest rate of 10% per annum.

Supplemental data: rf = 5% and E(rm) = 18%

Question: Determine the value of the firm before the debt-equity swap

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This solution carefully determines the value of the firm before the debt-equity swap.

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See Also This Related BrainMass Solution

Determining the Debt-Equity Mix

Can someone eloborate and, if necessary, correct my responses to the questions below?

A) Why is debt a comparatively cheaper form of finance than equity?

The repayments on the debt component are deductible from income of a business and the WACC calculations reflect this savings as well. Because debt is a fixed amount that can be repaid, with the owners of the business retaining full ownership after repayment. Equity makes one an owner of a (presumably growing business and therefore of potentially huge value and an indeterminate loss to the original owners.

B) If debt is cheaper than equity, why do companies approach the equity markets?

Companies appear to go public not to finance future investments and growth, but to rebalance their accounts after high investment and growth.

C) Can one minimize WACC when there is a constraint on rising debt? If so, how?

Yes, one area where focusing management attention could yield substantial value is the frequently neglected accounts receivable function. A company can liquidate assets as needed to lower WACC. In El Café' the owner swaps some debt for equity, renegotiated the interest and sold some assets.

D) What are the effects of a corporate tax on the WACC of a business?

First, the company cost of capital is a weighted average of the returns demanded by debt and equity investors. The weighted average is the expected rate of return investors would demand on a portfolio of all the firm's outstanding securities. Taxes are important because interest payments are deducted from income before tax is calculated. Therefore, the cost to the company of an interest payment is reduced by the amount of this tax saving.

E) Is minimizing WACC by having a largely debt-based capital structure a high-risk strategy, given the threat of bankruptcy in an overleveraged business? Explain your answer.

Yes, you're already overleveraged and teetering on bankruptcy, and yet you want to load up more on debt against equity. In the simulation, we tried to alleviate some of the leverage by swapping some debt for equity with real estate and renegotiated our loan.

F) What are the extraneous factors which impact the ability of a business to radically alter its debt-equity mix?

Taxation, would bias the financing choice towards debt if, for example, corporate income is taxed but interest payments are tax deductible. Informational asymmetries lead to different perceptions of risk. If investors perceive the risk to be higher than managers then cost of external finance via debt in higher than that of internal finance via retained earnings. Third, if firms accumulate more debt, say via the differential taxation mechanism described, then, their ability to meet interest payments from current earnings diminishes. This increases the probability of bankruptcy and as a result, the cost of both debt and equity. (Hart 2001)

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