Question

Firm C currently has 250,000 shares outstanding with current market value of $47.40 per share and generates an annual EBIT of $1,250,000. Firm C also has $1 million of debt outstanding. The current cost of equity is 8 percent and the current cost of debt is 5 percent. The firm is considering issuing another $2 million of debt and using the proceeds of the debt issue to repurchase shares (a pure capital structure change). It is estimated that the cost of the new debt will be 5.5 percent and that the cost of equity will rise to 9 percent with the additional debt. The marginal tax rate is 21 percent.

1.) What is the firm's net income after the recapitalization?

Note: The total interest costs that must be subtracted from EBIT must be calculated in two parts and then added:    

2.) How many shares are outstanding after the repurchase?

Answer 1

Interest on current Debt = Current debt * current cost of Debt

=1000000*5%

=50000

Interest on new issued Debt = issued New Debt * New cost of Debt

=2000000*5.5%

=110000

Total Interest = 50000+110000

=160000

EBIT =1250000

Net income formula = (EBIT - ínterest)*(1-tax rate)

=(1250000-160000)*(1-21%)

=861100

So firm's net income after the recapitalization is $861100

B.

Number of shares repurchased = Repurchased amount/stock price at repurchased date

=2000000/47.40

=42194 (round off)

Shares outstanding= number of existing shares - shares repurchased

=250000-42194

=207806

Shares outstanding after repurchase is 207806