QUESTION 22 our company is currently 100 percent equity fina

QUESTION 22 our company is currently 100 percent equity financed. The CFO is considering a recapitalization plan under which the company would issue long-term debt at a yield of 9 percent and use the proceeds to repurchase 20 percent of its commo stock. The recapitalization would not change the company\'s total assets, nor would it affect the firm\'s basic earning powe hich is 15 percent, or its operating expenses. The company currently pays taxes at a combined marginal rate of 40 perce xplain how the recapitalization is likely to affect (increase, decrease, no effect indeterminate) the companys net income eturn on equity, and WACC T T T Aral3 (12p) ords ath: p . Save and Submit to save and submit. Click Save All Answers to save all answers

Solution

Solution Let suppose Total Assets or Equity Capital $ 1,000 Basic Earning power Earning before Interest and Tax (EBIT)                     Total Assets 0.15 = EBIT $ 1,000 EBIT $ 150 Less Interest 0 Earning Before Tax (EBT) $ 150 Less Tax 40 % $ 60 Earning after Tax (EAT) $ 90 Return on Equity Earning After Tax (EAT) X 100 Euity share holder fund $ 90 x 100    =   9 % $1,000        WACC =   9% Since 100% capital is financed by euity capital only Now, Company issued Long term debt to Repurchase 20 % Equity Issue of Long term Debt $ 1,000 x 20% = $ 200 Equity Share ( $ 1,000-$200) $ 800 EBIT $ 150 Less Interest ( $ 200 x 9 %) $ 18 Earning Before Tax (EBT) $ 132 Less Tax 40 % $ 52.8 Earning after Tax (EAT) $ 79.20 Return on Equity Earning After Tax (EAT) X 100 Euity share holder fund $ 79.20 x 100 = 9.9 % $ 800             WACC Return on Equity (ROE)xweight of Equity+Yield on Debt (1- tax) x Weight 9.9 % x 800/1000 + 9 % (1-0.40)x 200/1000 = 9% Now Due to change in capital following effects are as under Decrease in EAT ($ 90-$79.20) $10.80 Increase in ROE 0.90% No Change on WACC Please feel free to ask if anything about above solution in comment section of the question.