Question

SuperOil has a debt-to-value ratio of 15%. Its revenue is 100,000 per year and cost is 70,000 per year forever. Its cost of debt is 7% and its cost of equity is 25%. It has 10,000 shares outstanding. Corporate tax rate is 35%.
(a) What is the firm’s value?
(b) What is its stock price?
(c) SuperBuyout is a leveraged buyout firm. It believes that SuperOil’s leverage is too low. It thinks that SuperOil’s firm value can increase with higher debt-to-value ratio and believes SuperOil’s optimal debt-to-value ratio is 25%. SuperOil’s cost of debt at this 25% debt-to-value ratio is 9%. SuperBuyout is considering buying all of SuperOil’s shares and increase SuperOil’s leverage to the optimal 25% level. Proceed from debt issuance will be given out to equityholderes as special dividend. What is the maximum premium SuperBuyout is willing to pay for SuperOil’s shares?

Answer 1

Answer:

a. The firm’s value is $88,909

b. The stock price is $7.56

c. The maximum premium SuperBuyout is willing to pay for SuperOil’s shares is $3,200

Explanation:

a. In order to calculate the firm’s value we would have to calculate the following calculation:

firm’s value=EBIT*(1-Tax rate)/WACC

EBIT*(1-Tax rate)=($100,000-$70,000)*(1-0.35)

EBIT*(1-Tax rate)=$19,500

WACC=weight of debt*cost of debt(1-t)+weight of equity*cost of equity

WACC=0.15*7*(1-0.35)+0.85*25

WACC=21.9325%

Therefore, firm’s value=$19,500/21.9325%

firm’s value=$88,909

b. In order to calculate its stock price we would have to calculate the following calculation:

stock price=Equity value/number of shares

Equity value=0.85*$88,909

Equity value=$75,572

Therefore, stock price=$75,572/10,000

stock price=$7.56

c. In order to calculate the maximum premium SuperBuyout is willing to pay for SuperOil’s shares we would have to make the following calculation:

maximum premium SuperBuyout is willing to pay=(stock price-value per share)*number of shares

maximum premium SuperBuyout is willing to pay=($7.56-$7.24)*10,000

maximum premium SuperBuyout is willing to pay=$3,200