Question

A company plans to announce that it will issue $1.6 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 6%. The company is currently all equity and worth $6.1 million with 280,000 share of common stock outstanding. After the sale of the bonds, the company will maintain the new capital structure indefinitely. The annual pretax earnings of $1.45 million are expected to remain constant in perpetuity. The tax rate is 21% a. What is the expected return on the company equity before the announcement of debt issue?

Answer 1

Given

In all equity, before the debt issue

Value of equity = $6.1 million

Pretax earnings EBIT = $1.45 million

Tax rate T = 21%

After tax Earnings = $1.45 million – 21%* $1.45 million = 1,450,000 – (0.21*1,450,000) = $1,145,500

Expected return on equity before debt issue

= Expected return on unlevered equity = Earnings after tax / Value of equity

Expected return on equity before debt issue = [$1,145,500/ $6,100,000] *100 = 0.1877868 * 100

Expected return on equity before debt issue =18.78%