Question

Olivia has just graduated from University and was hired by Manutech Inc. to help out with the company's financing decisions. The company has very high profit margins and generates large amounts of free cash flow. It currently has $500,000 in total assets and 10,000 shares outstanding. Because of generous investment tax credits and high rates of depreciation, Manutech does not pay any corporate tax. Manutech currently is all equity financed. The Chief Financial Officer ask Olivia to develop a financial strategy that could increase shareholder value. Olivia spends a week going over the company's financials, Olivia determines that there are three possible profit scenarios. Under the first scenario (recession), operating profits (EBIT) a S10,000 per year. Under the second scenario (expected), operating profits are $25,000 per year. Under the third scenario (expansion), operating profits are $40,000 per year re Olivia proposes the following plan, which will increase average earnings per share and return o equity. More specifically, she proposes that Manutech borrows money from a bank and use the proceeds to repurchase shares. As a result of this transaction, Manutech would have a debt-to- equity ratio of 2. The cost of borrowing from the bank is Please answer the following questions and document each step of your work (points will be deducted for not doing so). You must include a cover page with your submission.

Answer 1

Total assets - current	$500,000
(-) Assets in unlevered firm	$330,000
Existing external liabilities	$170,000
Calculation of interest:
Borrowing	$285,000
Cost of debt	3%
Interest	$8,550
Calculation of new equity:
Existing external liabilities	$170,000
(+) Borrowing	$285,000
Total debt	$455,000
(÷) New debt-to-equity ratio	2
New equity	$227,500
Calculation of total assets after borrowing:
New debt	$455,000
(+) New equity	$227,500
Total assets after borrowing	$682,500

As assets in unlevered firm are worth $330,000, it is the worth of 10,000 shares.

In the absence information about number of shares bought back, number of shares outstanding after borrowing can be calculated as:

A	Equity before borrowing	$330,000
B	Number of shares outstanding before borrowing	10,000
C	Equity after borrowing	$227,500
D	Number of shares outstanding after borrowing (B x C ÷ A)	6,894

		RECESSION	EXPECTED	EXPANSION
	EBIT	$10,000	$25,000	$40,000
	(-) Interest	$8,550	$8,550	$8,550
	EBT	$1,450	$16,450	$31,450
	(-) Tax @ 34%	$493	$5,593	$10,693
E	Net Income (Loss)	$957	$10,857	$20,757
F	Number of shares outstanding after borrowing	6,894	6,894	6,894
G	Total Assets	$682,500	$682,500	$682,500
H	Total equity after borrowing	$227,500	$227,500	$227,500
	Earnings Per Share (E ÷ F)	$0.14	$1.57	$3.01
	ROA (E ÷ G*100)	0.14%	1.59%	3.04%
	ROE (E ÷ H*100)	0.42%	4.77%	9.12%