Abstract
This paper discusses in detail a proposed change is company’s capital structure from 0 debt to 25% of the market value of the current Equity. The plan is to issue bonds for $ 3 375 000 at 9% interest and use the raised funds to repurchase 125 000 outstanding shares at the current market value of $ 27. This move will bring the total equity down from 10 000 000 to 6 625 000 and will increase the cost of equity from 11 to 13%. This will also bring our debt to equity ratio from 0 to 0.51. This level of debt is quite acceptable and common among the world’s leading companies. For example, Hewlett-Packard’s Debt-to-Equity Ratio as at October 31, 2014 was 0.73 (2014, YCharts. Hewlett-Packard Debt-to-Equity Ratio (Quarterly). Retrieved from http://ycharts.com/companies/HPQ/debt_equity_ratio). GM had it as high as 0.95 for Fiscal Year ending December 31, 2013 (2014, Equities. General Motors Co. Retrieved from http://markets.ft.com/research/Markets/Tearsheets/Financials?s=GM:NYQ)
The proposed recapitalization will also increase our earnings per share by $ 1 155 or by 22.9%. Total interest expense is going to be $ 303 750, which is low, compared to forecasted EBIT of $ 3 880 000. Time Interest Earned Ratio is going to be 13.10. Once again, let’s compare it to world leading companies: Microsoft as of June 2014 had it at 47.60 (2014, Stock Analysis On Net. Microsoft Corp. (MSFT). Long-Term Debt and Solvency Analysis. Retrieved from http://www.stock-analysis-on.net/NASDAQ/Company/Microsoft-Corp/Ratios/Long-term-Debt-and-Solvency). GM, for the period ending September 30, 2014 has this ratio at 10.52 (2014, Wikinvest. General Motors Co. Interest Coverage Ratio. Retrieved from http://www.wikinvest.com/stock/General_Motors_%28GM%29/Data/Interest_Coverage_Ratio).
Impact of Proposed Change of Company Capital Structure
What impact will the utilization of the debt on the value of the company?
The company’s assets value is $ 10 000 000, the book value of the assets equals the market value and there is no debt. Therefore we can safely assume that the total equity is equal to total assets. Total equity equals 10 000 000. The current number of outstanding shares is 500 000. By dividing the total equity by the number of outstanding shares we get the book value of one share. It’s $ 20. The market value of one share is $ 27. To determine the Price/Book ratio we need to divide market price by the book price. The current Price/Book ratio for our company is 1.35 ($ 27 / 20). Using the Price/Book ratio we can calculate the market value of the Equity. It is $ 10 000 000 times 1.35, equals $ 13 500 000. The company plans to issue bonds, worth 25% of the current market value of the equity and repurchase 25% of the shares at market value. We can calculate the total debt by using these figures. Total debt will come up to 3 375 000 (13 500 000 X 25%). Using the total debt figure we can calculate the new equity by subtracting debt from existing total equity of $ 10 000 000. The new equity will be 6 625 000 (10 000 000 – 3 375 000). The new number of shares outstanding can be calculated by dividing the debt figure by the market price of one share. It will be 500 000 – (3 375 000 / 27 = 125 000), or 375 000. The new book value per share will be calculated as follows: 6 625 000 divided by 375 000 equals $17.67. New price/book ratio will be 27 / 17.67, or 1.53. The new market value of equity is going to be 6 625 000 times 1.53 equals $ 10 125 000. As a result of the recapitalization the market value of the Equity will go down.
What’s going to be the company’s EPS after the recapitalization?
The company’s Earnings Per Share will be calculated as follows: earnings after taxes divided by the number of shares outstanding. After the recapitalization the EAT will be $ 2 324 562 (EBIT of $ 3 880 000 – interest 303 750 – income tax 1 251 687). Divided by the number of shares outstanding (375 000) we get $ 6 199. It is $ 1 155 more than before the recapitalization.
What’s going to be the company’s new stock price?
The new book value per share will be calculated as follows: new equity 6 625 000 (10 000 000 – 3 375 000 debt) divided by new number of shares outstanding 375 000 (3 375 000 of debt used to repurchase part of the outstanding stock at a market price of $ 27) equals $17.67.
What’s the times interest earned ratio at each probability level?
The Times Interest Earned ratio or Interest Coverage Ratio is calculated by dividing EBIT by Interest Expense. The interest expense is proposed debt of 3 375 000 times 9% interest, which is 303 750. The results of calculations are given in the table below:
Please note, that the forecasted value of EBIT, if calculated correctly, comes to $ 3 980 000 which is $ 100 000 more than is given in the task.
Conclusion
The proposed recapitalization of the company will benefit the shareholders because it D/E ratio will be low. The risk will increase only slightly. At the same time the EPS will increase 22.9%, which makes the company more attractable to the investors.
References
2014, YCharts. Hewlett-Packard Debt-to-Equity Ratio (Quarterly). Retrieved Dec.7, 2014 from http://ycharts.com/companies/HPQ/debt_equity_ratio.
(2014, Equities. General Motors Co. Retrieved Dec.7, 2014 from http://markets.ft.com/research/Markets/Tearsheets/Financials?s=GM:NYQ).
2014, Stock Analysis On Net. Microsoft Corp. (MSFT). Long-Term Debt and Solvency Analysis. Retrieved Dec.7, 2014 from http://www.stock-analysis-on.net/NASDAQ/Company/Microsoft-Corp/Ratios/Long-term-Debt-and-Solvency.
(2014, Wikinvest. General Motors Co. Interest Coverage Ratio. Retrieved Dec. 7, 2014 from http://www.wikinvest.com/stock/General_Motors_%28GM%29/Data/Interest_Coverage_Ratio).
