Question

Executive Cheese has issued debt with a market value of $114.91 million and has outstanding 14.30 million shares with a market price of $10 a share. It now announces that it intends to issue a further $64.39 million of debt and to use the proceeds to buy back common stock. Debtholders, seeing the extra risk, mark the value of the existing debt down to $62 million.

a. Calculate the market price of the stock following the announcement. (Round your answer to 2 decimal places.)

Price of the stock $

b. How many shares can the company buy back with the $64.39 million of new debt that it issues? (Enter your answer in millions. Round your answer to 1 decimal place.)

Number of shares million

c. What is the market value of the firm (equity plus debt) after the change in capital structure? (Enter your answer in millions. Round your answer to 2 decimal places.)

Market value $ million

d. What is the debt ratio after the change in structure? (Round your answer to 2 decimal places.)

Debt ratio

e. Who (if anyone) gains or loses?

The investors in the existing debt lose while the shareholders gain.

The investors in the existing debt gain while the shareholders lose.

No one gains or loses.

Answer 1

a). The market value of the firm’s equity increases by $50.52 million, the amount of the decrease in the market value of the firm’s existing debt. Therefore, the price of the stock increases to:

($143 million + $50.52 million)/14.30 million shares = $13.53

b). Since the market price of the shares is $13.53, the company can buy back:

$64.39 million/$13.53 = 4.76, or 4.8 million shares

c). After the change in capital structure, the market value of the firm is unchanged:

Equity + debt = [($114.91 million/$10) x $13.53] + $126.39 million

= $155.51 million + $126.39 million = $281.90 million

d). After the change in structure, the debt ratio is:

Debt/(debt + equity) = $126.39 million/$281.90 million = 0.45

e).The investors in the existing debt lose $50.52 million while the shareholders gain this $50.52 million. The value of each share increases by:

$50.52 million/14.30 million shares = $3.53