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River Cruises is an entirely equity financed company
River Cruises is an entirely equity financed company. The current position of the company is as follows: Number of shares Price per share Operating income Earning per share A tATA 124000 14 152,000 1.23 The CFO of the company is proposing to issue new debt and repurchase the share using the cash from issuing the debt as follows: Amount of debt issue $ 868,000 Interest rate of debt 7% $
a. What is the market value of the company now?
b. What is the return on equity of the company? Assume that there is no tax.
c. What will be value of the company after the proposed change in capital structure (assume no-tax world)?
d. What will be the return on equity and return on asset (weighted average cost of capital) with the proposed change assuming no-tax world?
e. What will be the value of company after the proposed changes in capital structure assuming that the company pays 25% tax?
f. What will be the return on equity and return on asset (weighted average cost of capital) with the proposed change assuming that the company pays 25% tax?
g. If the proposed new capital structure induces agency costs and bankruptcy costs, what will the value of the after company? Given that the present value of expected agency cost is $10,000 and the present value of expected bankruptcy cost is $15,000. The tax rate is 25%.
Expert Solution
Answer
a.
Current Market Value of Company = Market Price per share * No. of shares
=124000*14
= $1736000
b.
Assumption: Face Value price per share = 10
Return on Equity = (Operating Income/ Shareholder's Equity)*100
Opearting income = 152000
Shareholder's equity = 124000*10 = 1240000
This imples,
Return on Equity = 12.26%
c.
Assumption: There would be no change in P/E ratio = Price per share/earnings per share
This implies P/E = 14/1.23
Shares bought back will be = 868000/14 = 62000
Balace shares = 124000*62000 = 62000
Operating Income after capital restructuring = 152000 - Interest
= 152000 - (868000*7%)
= $91240
Earnings per share ("EPS") post capital restructuring = 91240/62000 = 1.47
New Price = EPS*P/E
= 1.47*14/1.23
= $16.73 / share
Value of Company = Value of Equity + Value of Debt
= 16.73*62000 + 868000
=$ 1905260
d.
Return on Equity = (New Operating income/ Shareholder's Equity)*100
= 91240/ (62000*10)
= 14.72%
Return on Assets = (New Operating income/ Shareholder's Equity + Value of debt)*100
= = 91240/ (62000*10 + 868000)
=6.13%
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