Question

Big Blue Banana (BBB) is a clothing retailer with a current share price of $10.00 and with 25 million shares outstanding. Suppose that Big Blue Banana announces plans to lower its corporate taxes by borrowing $100 million and using the proceeds to repurchase shares.

Assuming perfect capital markets, the share price for BBB after this announcement is closest to:

A) $11.40.

B) $10.85.

C) $10.00.

D) $8.60.

Answer 1

The Value of company before borrowing

= Current share price * shares outstanding

= 10 * 25

= 250 Million

Now, The company has raised debt to save the corporate tax, So, the tax savings earning will increase the equity value.

The tax rate = 35% (Assumed)

Value after Borrowing = Value before borrowing + (Taxes) * Debt (Amount Borrowed)

= 250 + (0.35)*100

= 250 + 35

= 285 Million

value per share = Total value of company / Number of shares outstanding

we had given number of shares outstanding = 25 million

value per share = 285 / 25

= $11.40

Note: The Value per share can be changed if the tax rate percentage is changed