Question

Buffalo National Corp. (BNC) is currently an all-equity firm worth $320 million with 50 million common shares outstanding. BNC plans to announce that it will issue $120 million of perpetual debt (i.e., bonds) in order to buy back shares. BNC currently generates annual pretax earnings (EBT) of $80 million, and this level of earnings is expected to remain constant (i.e., EBIT will be $80 million) in perpetuity after the debt issuance and capital restructuring. The bonds will sell at par with an 8% annual coupon rate. BNC’s tax rate is 35%. BNC will maintain the new capital structure indefinitely. There is no financial distress cost, other agency cost, or personal income tax.
Required:
a. In the market-value balance sheet of BNC before announcing the debt issuance, what is the market value of equity?
b. What is the stock price of unlevered BNC?
c. What is the expected return on equity before the announcement of the debt issuance (i.e., the cost of unlevered equity)?

Answer 1

Answer:

The solution as per the given problem is provided below throughout the explanation portion below.

Explanation:

The given values are:

Debt issued,

= 120

Pretax earnings,

= 80

Tax,

= 35%

All equity firm,

= $320

Number of common stock,

= 50

(a)

Balance sheet before the debt issue's announcement will be:

Assets                                 320

Debt                                      0

Equity                                   320

then,

The total will be "320".

(b)

The per share price will be:

= $\frac{Equity}{Number \ of \ common \ stock}$

= $\frac{320}{50}$

= $6.40$

or,

After tax, the net income will be:

= $EBIT(1-t)$

= $80(1-0.35)$

= $80\times 0.65$

= $52$

(c)

The return on equity will be:

= $\frac{Net \ income \ after \ taxes}{Value \ of \ equity}$

= $\frac{52}{320}$

= $0.1625$

or,

= $16.25$ (%)