Strade plc is an all equity financed company The Finance Dir

Strade plc is an all equity financed company. The Finance Director suggested in a recent meeting with the Board of Directors a capital restructuring to introduce some debt in the company’s financing to take advantage of the tax benefits of debt. With a corporate tax rate of 40%, he argued that the advantages make the adjustment worthwhile. His proposal is to repurchase 30 million of the company’s 100 million ordinary shares outstanding, which will be financed by an issue of debt at 8%. The company’s shares are currently trading at £0.75. Whilst the company has no growth prospects, it is anticipated that the company can sustain its expected earnings for the next year of £200 million before tax indefinitely into the future. The proposal has been discussed with the company’s investment bank and no problems are anticipated in its implementation.

Determine the firm’s WACC following the restructuring and find the value of the geared firm.

Solution

Answer )

The repurchase of shares = 30 million, Value of repurchase share = 30 * 0.75 =£22.5 millions

The repurchase share financed by £22.5 millions @ 8% debt., so ,value of debt =  £22.5 millions

Remaining outstanding share = 70 millions , Value of Outstanding shares = 70 * 0.75 = £ 52.5 millions

Value of capital = Equity + debt = £ 52.5 +£22.5 = £75 million

TAx = 40% , interest rate of Debt = 8% , effective Interest rate ( cost of debt ) = 8 ( 1-40%) = 4.80% .

Earning =  =£200 millions before tax , the interest of debt has already paid

EAT = £200 (1-40%) = £120 millions (amount for share holders )

earning per share equity = EAT / Number of outstanding share = £120/ 70 = 1.714 /share

Cost of equity = earning per share equity / Value of share = 1.714 / 0.75 = 228.53%

Firm WACC = Weight of debt * cost of debt + Weight of equity * cost of equity

= 22.5/75 * 8% + 52.5/75 * 288.53% = 204.37%

Value of firm with perpetual income = Income / wacc = £200 / 204.37% =£ 97.8612 Million

Note :The answer seems to be little discomfortable .Kindly check the data in the question , as answer is true for given data