Mini-Case: Capital Structure: Theory and Taxes DataCore Inc. currently has an al

Question

Mini-Case: Capital Structure: Theory and Taxes DataCore Inc. currently has an all-equity capital structure. However, the firm is considering a recapitalization that would structure the firm with 25% debt and 75% equity by issuing an appropriate amount of debt and repurchasing an equal amount of common stock; the debt is expected to have a 5% coupon rate. The firm expects the following scenarios over the next year for EBIT obabili EBIT $800,00 $525,00 |$ 75,000 ood 35% veragel 40% oor 25% ew PDF The firm currently has 200,000 shares of common stock outstanding at $43 per share. The firm is in a 0% tax bracket. 1. Determine the expected earnings before interest and taxes, net income, and earnings per share (a) if the firm maintains its current unlevered capital structure and (b) if it recapitalizes at 25% debt and uses the proceeds to repurchase conm 2. Following the assumptions behind M&M;'s Proposition I, calculate the stockholders' required rate of return of the firm in an unlevered versus a levered state. Calculate the value of the levered firm, separating it into debt and equity components. Also, calculate the weighted average cost of capital (WACC) for the firm in a levered versus an unlevered state. 3. Assuming the firm is in a 35% corporate tax bracket, determine the value of the unlevered firm versus the value of the levered firm

Explanation / Answer

2. Stockholder's Required Rate of Return in Unlevered state-

Following is the formula of M & M Proposition I -

rE = r0 + D /E x (r0 rD)

where rE = Return on Equity

r0 = Cost of Capital if Firm was financed entirely from equity

rD = Cost of Debt

Here, r0 will be -

Net income - 508750

Equity Capital - 8600000

r0 - 5.92%

So, Stockholder's Required Rate of Return in Unlevered state will be -

rE= 5.92 + 0/1 x (5.92-5) that is 5.92%

Stockholder's Required Rate of Return in Levered state will be -

rE = 5.92 + .25/.75 x (5.92-5) that is 5.92 + 0.31 = 6.23%

Value of Levered firm-

Equity Component- Net income in levered state/rE, that is 401250/.0623 = $ 6440610

Debt Component -  2150000(as rD is 5%), therefore , total value of levered firm- 8590610

WACC- Levered State- Weight of Debt/(Debt + Equity) x rD + Weight of Equity/(Debt + Equity) x rE

So, Using above formula- 0.25/1 x 5% + 0.75/1 x 6.23% = 5.92%

Using the same Formula, WACC in Unlevered state will be-

WACC = 0 + 1/1 x 6.23 = 6.23%

3. Value of Unlevered Firm with Tax bracket of 35%-

Net Income after Tax = 65% of $ 508750 = $ 330687.5

Value of Firm = 330687.5/5.92% = $ 5585937

Value of Levered Firm-

Net Income afer tax of 35% = 65% of 401250 = $ 260812.5

Value of Firm = 260812.5/6.23% = $ 4186396 + Debt of $ 2150000

Therefore total value of Levered firm will be - 6336396

1. Expected EBIT in next year- Probability EBIT Amount 0.35 800000 280000 0.40 525000 210000 0.25 75000 18750 Expected EBIT for next year 508750 Total Amount of Capital- No. of Shares 200000 value per share 43 Amount of Equity Capital 8600000 25 % of Equity to be repurchased by issuing Debt 2150000 Remaining Equity after Recapitalisation 6450000 Coupon amount of Debt (5%) 107500 a) Unlevered Capital Structure Amount in $ Particulars Unlevered Capital Structure EBIT 508750 Interest Expense on Debt - EBT 508750 Tax @ 0% - Net Income 508750 No. of Equity Shares 200000 EPS 2.54 b) Levered Capital Structure Amount in $ Particulars Levered Capital Structure EBIT 508750 Interest Expense on Debt 107500 EBT 401250 Tax @ 0% - Net Income 401250 No. of Equity Shares 150000 EPS 2.68

Related Questions

Navigate

• Browse (All)
• Browse M
• Subjects

---