Question

Arizona Coffee, Inc. is an all-equity firm, and has just announced that it will raise $5...

  1. Arizona Coffee, Inc. is an all-equity firm, and has just announced that it will raise $5 million perpetual debt to repurchase some of its shares (in about a month’s time). Suppose the firm currently has 500,000 shares outstanding, and that its shares were trading at $20/share before the announcement. Further assume that the marginal corporate tax rate is 40% and that it is highly unlikely that Arizona Coffee will become financially distressed after raising $5 million in debt (i.e. PV of financial distress costs is approximately zero). How many shares will Arizona Coffee Inc., repurchase (in about a month’s time)?

  1. 208,334 shares
  2. 217,392 shares
  3. 234,890 shares
  4. 238,981 shares
  5. 276,981 shares
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Answer #1

Correct answer: A. 208,334 shares

Before announcement:

Share price = $20

Outstanding shares = 500,000

Value of Firm (All equity) = 20*500,000 = $10,000,000

After announcement:

Debt to be raised = $5,000,000

Tax rate = 40%

Thus, According to M&M proposition-1 with taxation-

Value of Firm (after announcement) = 10,000,000 + 0.40*5,000,000 = $12,000,000

Share price (after announcement) = 12,000,000/500,000 = $24

Thus, No. of share to be repurchased:

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