Posted: June 22nd, 2020
Finance question – capital structure part 2
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Company X has the following capital structure:
Short Term Debt/Current Portion of Long Term Debt
£1,700,000
Long Term Debt
£9,700,000
Total Equity
£18,000,000
Shares Outstanding
1,700,000
Further, i have following market information from the New Financial Times.
Stock Price (per share)
£ 27
Current Yield to Maturity on outstanding Bond
0.90%
Cost of unlevered equity is 10 %.
I will need to demonstarte that: in a “real world” market imperfections like taxes can’t be ignored. As interest payments create a vlauable tax shield, the stock price should increase if a frim decides to increase its debt., ie higher leverage higher firms value.
I should demonstarte that through:
-examine the impact of a) issuing 1 bln (pounds) in new debt (adding modest level of debt) and b) issuing 5 bln in new debt (adding higher level of debt). In both cases i plan to us the proceeds to repurchase stock
assumptions/notes:
– assume tax rate of 40%
– should first analyze scenario with 1bln new debt. Assume company x keeps this debt outstanding forever,to determine the present value of the tax shield of the new debt
– to findout new market value of equity. New market value of equity = existing mkt value +tax shield.
– find out new market value of equity after repurchase
– find out the new share price
– new no. of shares outstanding := given number minus no. of shares purchased)
– now find out Debt to equity ratio based on a) book values and b) market values
– repeat above for 5 billion new debt issuance
Will need to refer to Modigliani/Miller theorem as well.
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