Question

ABCD has 50,000 shares outstanding that sell for $30 each. The firm has an operating income of $100,000 and pays no taxes. The firm contemplates a restructuring that would have 40% debt which will be used to repurchase stock. The cost of debt is 7%. Determine the value of the firm, EPS, and rate of return on the stock before and after the proposed restructuring.

Answer 1

Calculation of EPS and Value of the firm before Restructring Plan

EPS = Operating income/share outstandings

EPS = 100,000/50,000 = $2 per share

Value of the firm = 50,000*30 = $1,500,000

PE Ratio = 30/2 = 15 times

Calculation of EPS and Value of the firm after restructring assuming PE ratio is same

Debt = 1,500,000*40% = 600,000

Equity = 1,500,000*60% = 900,000

Number of shares = 900,000/30 = 30,000

EPS = (100,000 - 600,000*7%)/30,000 = 1.93

Market price = 1.93*15 = $29 per share

Equity value = 29*30,000 = $870,000

Firm Value = 870,000 + 600,000 = 1,470,000

So, due to restructring plan

EPS decrease by $ 0.067 per share and value of firm decarese by $ 30,000 (1,500,000 - 1,470,000)