Intermediate Financial Management (with Thomson One)

Table 15-4
536 • Part 4 Strategic Financing Decisions
Strasburg’s Stock Price and Earnings per Share
Percent Market Market Number of
Financed Value of Value Value Shares after Net Earnings
with Debt, Firm, of Debt, of Equity, Stock Price, Repurchase, Income, per Share,
w d V D S P n NI EPS
(1) (2) a (3) b (4) c (5) d (6) e (7) f (8) g
0% $200,000 $ 0 $200,000 $20.00 10,000 $24,000 $2.40
10 206,186 20,619 185,567 20.62 9,000 23,010 2.56
20 212,540 42,508 170,032 21.25 8,000 21,934 2.74
30 217,984 65,395 152,589 21.80 7,000 20,665 2.95
40 222,222 88,889 133,333 22.22 6,000 19,200 3.20
50 216,216 108,108 108,108 21.62 5,000 16,865 3.37
60 200,000 120,000 80,000 20.00 4,000 13,920 3.48
Notes:
aThe value of the firm is taken from Table 15-3.
bThe value of debt is found by multiplying the percent of the firm financed with debt in Column 1 by the value of the firm in Column 2.
cThe value of equity is found by subtracting the value of debt in Column 3 from the total value of the firm in Column 2.
dThe number of outstanding shares prior to the recap is n0 10,000. The stock price is P [S (D D0 )]/n0 [S D]/10,000.
eThe number of shares after the recapitalizations is n S/P.
fNet income is NI (EBIT rdD)(1 T), where EBIT $40,000 (taken from Table 15-1), rd comes from Table 15-2, and T 40%.
gEPS NI/n.
of $222,222. Notice that their total wealth increases from its original level of
$200,000 to the new level of $222,222, a gain of $22,222. This is exactly equal to
the increase in total value experienced by Strasburg, so the shareholders reap the
full rewards of the recapitalization.
Prior to the announced recap, Strasburg had a $200,000 market value of
equity and 10,000 shares of stock outstanding (n 0 ). Therefore, its stock price prior
to the recap was $20 per share ($200,000/10,000 $20).
To find the price per share after the recap, consider the sequence of events.
(1) The company announces the recap and issues new debt. (2) The company uses
the proceeds from the debt issue to repurchase shares of stock. These events don’t
occur exactly simultaneously, so let’s examine each event separately.
Strasburg Issues New Debt Strasburg announces its plans to recapitalize,
and borrows $88,889. It has not yet repurchased the stock, and so the $88,889
of debt proceeds are temporarily used to purchase short-term investments such as
T-bills or other marketable securities. Using the corporate valuation model from
Chapter 11, the total corporate value is now equal to the value of operations, calculated
by discounting the expected free cash flows by the new WACC, plus the
value of any nonoperating assets such as short-term investments. Therefore, Strasburg’s
total value after issuing debt but before repurchasing stock is
Total corporate value Value of operations Value of short-term investments
$222,222 $88,889 $311,111