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.

Suppose that BBB pays corporate taxes of 21% and that shareholders expect the change in debt to be permanent. Assuming that capital markets are perfect except for the existence of corporate taxes, the share price for BBB after this announcement is closest to:

A) $10.00.

B) $10.84.

C) $8.60.

D) $11.40.

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 = 21% (Given)

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

= 250 + (0.21)*100

= 250 + 21

= 271 Million

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

we had given number of shares outstanding = 25 million

value per share = 271 / 25

= $10.84

The correct option is B