Newkirk, Inc., is an unlevered firm with expected annual earnings before taxes o
ID: 2658428 • Letter: N
Question
Newkirk, Inc., is an unlevered firm with expected annual earnings before taxes of $22.9 million in perpetuity. The current required return on the firm’s equity is 16 percent, and the firm distributes all of its earnings as dividends at the end of each year. The company has 1.49 million shares of common stock outstanding and is subject to a corporate tax rate of 34 percent. The firm is planning a recapitalization under which it will issue $31.9 million of perpetual 10.9 percent debt and use the proceeds to buy back shares.
Calculate the value of the company before the recapitalization plan is announced. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
What is the price per share? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
Use the APV method to calculate the company value after the recapitalization plan is announced. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
What is the price per share after the recapitalization is announced? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
How many shares will be repurchased? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
What is the price per share after the recapitalization and repurchase? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
Use the flow to equity method to calculate the value of the company’s equity after the recapitalization. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
Newkirk, Inc., is an unlevered firm with expected annual earnings before taxes of $22.9 million in perpetuity. The current required return on the firm’s equity is 16 percent, and the firm distributes all of its earnings as dividends at the end of each year. The company has 1.49 million shares of common stock outstanding and is subject to a corporate tax rate of 34 percent. The firm is planning a recapitalization under which it will issue $31.9 million of perpetual 10.9 percent debt and use the proceeds to buy back shares.
Explanation / Answer
a1). VU = [(Pretax Earnings)(1 - Tc)] / R
= [$22,900,000(1 - 0.34)] / 0.16
= $15,114,000 / 0.16 = $94,462,500
a2). Price per share = $94,462,500 / 1,490,000 = $63.40
b1). The adjusted present value of a firm equals its value under allequity financing plus the net present value of any financing side effects. In this case, the NPV of financing side effects equals the aftertax present value of cash flows resulting from the firm’s debt. Given a known level of debt, debt cash flows can be discounted at the pretax cost of debt, so the NPV of the financing effects is:
NPV = Proceeds ? Aftertax PV(Interest payments)
NPV = $31,900,000 ? (1 ? .34)(.109)($31,900,000) / .109
NPV = $31,900,000 - $21,054,000 = $10,846,000
So, the value of the company after the recapitalization using the APV approach is:
V = $94,462,500 + 10,846,000
V = $105,308,500
b2). Since the company has not yet issued the debt, this is also the value of equity after the announcement. So, the new price per share will be:
New share price = $105,308,500 / 1,490,000
New share price = $70.68
c1). The company will use the entire proceeds to repurchase equity. Using the share price we calculated in part b, the number of shares repurchased will be:
Shares repurchased = $31,900,000 / $70.68
Shares repurchased = 451,350 shares
c2). The new number of shares outstanding will be:
New shares outstanding = 1,490,000 ? 451,350
New shares outstanding = 1,038,650 shares
The value of the company increased, but part of that increase will be funded by the new debt. The value of equity after recapitalization is the total value of the company minus the value of debt, or:
New value of equity = $105,308,500 ? 31,900,000
New value of equity = $73,480,500
So, the price per share of the company after recapitalization will be:
New share price = $73,480,500 / 1,038,650
New share price = $70.75 per share
d). In order to value a firm’s equity using the flowtoequity approach, we must discount the cash flows available to equity holders at the cost of the firm’s levered equity. According to Modigliani Miller Proposition II with corporate taxes, the required return of levered equity is:
RS = R0 + (B/S)(R0 ? RB)(1 ? TC)
RS = .16 + ($31,900,000 / $73,480,500)(.16 ? .109)(1 ? .34)
RS = 0.16 + 0.0146 = .1746, or 17.46%
After the recapitalization, the net income of the company will be:
NI = (EBIT - Interest)(1 - T)
NI = [$ 22,900,000 - ($31,900,000 x 0.109)](1 - 0.34)
= [$22,900,000 - $3,477,100](1 - 0.34) = $19,422,900(1-0.34) = $12,819,114
The firm pays all of its earnings as dividends, so the entire net income is available to shareholders. Using the flowtoequity approach, the value of the equity is:
S = Cash flows available to equity holders / RS
S = $12,819,114 / .1746
S = $73,414,525.45, or $73,414,525