Modigliani–miller theorem, Corporate Finance

The FrontczakCompany is expecting to generate (after tax)a Net Income of $250 millionannuallyandindefinitely (in perpetuity), and this amount is paid out annually as dividends.

The company’s stock has a ?eta of 1.2, the risk free rate or return (RFR) is 4% and the market risk premium (MRP) is 6%.

The company is financed at a debt-to-value ratio of 0.4.  The company can borrow at a pre-tax cost of 6%, and the tax rate is 35%.  There are 10 million shares of common stock outstanding.

a)    What is the stock price?

b)    Assume you are in a Modigliani–Miller(M&M) theorem world with taxes.

The firm is considering a levered recapitalization through an issue of $400 million in
new 30-year debt (which is expected to be rolled over indefinitely - in perpetuity) and result
in $24 million annually ininterest payments.

The 2 options being considered for the $400 million debt proceeds are:
(1) use it to finance an open market stock buyback program and
(2) use it to pay a one-time special dividend.

The firm will announce the $400million recapitalization and its choice (1 or 2) simultaneously.

Assume there is no additional information content to the announcement of the recapitalization and of the specific choice (1 or 2) – M&M with taxes world.  

(i)    What do you expect to be the stock price upon the announcement of the recapitalization andchoice (1) versusthe stock price upon the announcement of the recapitalization and choice (2)?

(ii)    Continuing, what do you expect to bethe;

(a). Stock priceand(b). Earnings per Share (EPS)after the completionof:

- repurchasing the shares and alternatively,

-  paying out the special dividend.

Note: You need to calculate and show the (a) Stock priceand (b). EPS for both- repurchasing  the shares &- paying the special dividend.

Posted Date: 4/5/2013 5:24:48 AM | Location : United States

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