Maria Suarez returned to her office afteer spending the afternoon meeting with h
ID: 2770252 • Letter: M
Question
Maria Suarez returned to her office afteer spending the afternoon meeting with her firm's investment bankers. Suarez was CFO of MidCo Ind., a mid-sized manufacturing firm, and she was taking a hard look at its capital structure and payment policy. Bonita felt that MedCo was underlevered and potentially not taking full advantage of the tax benefits of debt. Further complicating matters, MidCo's institutional investors had been clamoring for either a repurchase or a special dividend.
One possibility floated by her investment bankers was a "leveraged recap", in which MidCO would issue debt and use the proceeds to repurchase shares. MidCo Industries has 20 milion shares outstanding with a markket price of $15 per share and no debt. The firm had consistenly stable earnings and pays a 35% tax rate. MidCo's investment bankers proposed that the fimr borrow $100 million on a permanent basis throulgh leveraged recap in which it would use the borrowed funds to repurchase outstanding shares.
As Suarez sat down at her desk, she stared at her notepad. She had written down several questions that she would need to answer befoore making her decision.
1. What are the tax consequences of the recap?
2. Based only on the tax effects and the Valuation Principle, what will be the total value of the firm after the recap?
a. How much of the new value will be euity?
b. How much will be debt?
3. At what price should MidCo be able to repurchase its shares?
4. Who benefits from the recap? Who loses?
5. What other costs or benefits of the additional leverage should MidCo's managers consider?
6. If MidCo's managers decide to issue the debt and distribute the tax shield as a special dividend instead of repurchasing shares, what will the dividend per share be?
Explanation / Answer
1. When company raise any funds through debt, interest payment on debt is tax deductable, hence our tax burden will be reduced.Eg. suppose a company has no debt in his capital sutructure and got a profit of $10,000.supposse tax rate is 40%, it has to pay $4,000 towards tax. Suppose the company has debt of $100,000 with 5% interest in its capital structure, they it's tax burden is only $2,000 (40% of ( $10000-$5,000 interest)).
Due to this tax advantage, company's effective interest rate will be lesss than its interest rate.
2. Value of the Firm = Value of equity + Value of Debt = $20 million + 100 million = $120 million
a. How much of the new value is equity = Present equity worth - Repurchase of equity = $20million x $15 - $100 million = $300 - $100 million repurchase of equity = $200 million.
b. How much will be Debt = $100 million
3. At what price, Midco. be able to repruchase its shares? MidCo can repurcahse its shares to its market price i.e $15 per share, to calculate the effect of repurchase, company present profits are not available, so that we cannot calculate P/E ratio which decides the price of share after repurchase
4. Due to repurchase of shares, company shareholders will benefit as their earnings per share will increase than earnler due to decrease in number of outstnading shares. In this case, before repurchase, Mid cap outstnading shares are 20 millon, but after repurchase number of shares outstnding will be reduced,hence earnings per share will increase. Shareholders who sold their shares to the company will be the loosers as they are misssing of enjoying capital gains.
5. Other costs the MidCo's managers should consider is 'floatation cost of debt' i.e costs related to issue of bonds. For repurchase, company has to use its retianed earnings which involves opportunity cost. And other benefits other than tax, Midco's managers should condider increase in the value of share after repurchase, that naturally will increase.
6. Tax shield can be calculatd by multiplying interest expeses with tax rate. In the given problem, Interest expenses are not availabel,suppose, we assume 6% interest on debt of $100 million, then interest expense is $ 6million, then tax shied to the Midco's is $2.1 million (ie. $6 million x 35% tax), this $2.1 million tax shield suppose distributed in the form of dividend, each share will get a dividend of $1.05 (ie. tax shield $2.1 million divided by 20 million outstanding shares)