Intermediate Financial Management (with Thomson One)

Recall from Chapter 11 that the value of equity is the total corporate value
minus the value of all debt. Therefore, the value of equity after the debt issue but
prior to the repurchase, S P , is
SP = Value of equity after the debt issue but prior to the repurchase
= Total corporate value Value of all debt
$311,111 $88,889 $222,222
Although the corporate valuation model will always provide the correct value,
there is a quicker and more intuitive way to determine S p in a recapitalization. S p
reflects the wealth of the shareholders under the new capital structure, and, as we
noted earlier, this is equal to the value of their equity after completion of the
recapitalization plus the cash they receive in the repurchase. If all newly issued
debt is used to repurchase stock, then that amount is D D 0 . Therefore, S p is
S p S (D D 0 )
$133,333 ($88,889 $0) $222,222
This is exactly the same value as calculated above, but it can be computed with
fewer steps and is perhaps a little more intuitive.
The price per share after issuing debt but prior to repurchasing stock, P p , is
P p Price per share after debt issue but prior to repurchase
Value of equity after debt issue but prior to repurchase
Number of shares outstanding prior to repurchase
S p /n 0
$222,222/10,000 $22.22
Strasburg Repurchases Stock What happens to the stock price during the
repurchase? The short answer is “nothing.” It is true that the additional debt will
change the WACC and the stock price prior to the repurchase, but the subsequent
repurchase itself will not affect the stock price. 23 To see why this is true, suppose
the stock price was lower right before the repurchase than after the repurchase. If
this were true, it would be possible for an investor to buy the stock the day before
the repurchase and then reap a reward the very next day. Current stockholders
would realize this and would refuse to sell the stock unless they were paid the
price that is expected immediately after the repurchase.
23 As we discuss in Chapter 17, a stock repurchase may be a signal of a company’s future prospects, or it may be the way
a company “announces” a change in capital structure, and either of those situations could have an impact on estimated
free cash flows or WACC. However, neither situation applies to Strasburg.
Chapter 15 Capital Structure Decisions: Part I • 537