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

At present, The Total assets are $ 500,000. the Outstanding Shares are 10,000 shares. Therefore value per share is $ 500,000 / 10,000 shares = $50 per share.

At the end of first year, when there is no debt and all the assets are equity financed,

Particulars	Scenarios (Amount in $)
	Recession	Expected	Expansion
Total Assets at Present (a)	500000	500000	500000
Operating/ Net Profits for the Year (b)	10000	25000	40000
Total Assets at the end of the Year (a+b)	510000	525000	540000
No. of Shares Outstanding	10000	10000	10000
Value of Each Share = (a+b) / No. of Shares Outstanding	51	52.5	54

Let us find out the Value per share at the end of Year 1 as per Olivia's proposed Financing arrangement.

The proposed Debt to Equity ratio is 2.

=> Amount to be borrowed to repurchase outstanding shares = (No. of shares outstanding at present x Value per share at present) x 2/3

= (10,000 x 50) x 2/3

= $333,333.33

Therefore, in the proposed arrangement, the debt will be $333,333.33

So, Interest on debt for 1 year at 3% / year = $333,333.33 x 3% = $10,000 (approx.)

No. of shares to be repurchased = $333,333.33 / $50 per share = 6666 shares

Calculations of Value per share in Proposed Arrangement

Particulars	Scenarios (Amount in $)
	Recession	Expected	Expansion
Total Assets at Present (a)	500000	500000	500000
Operating Profits	10000	25000	40000
Less: Interest Expenses	-10000	-10000	-10000
Net Profits (b)	0	15000	30000
Total Assets at the end of the Year (a+b)	500000	515000	530000
Less: Debt borrowed	-3,33,333.33	-3,33,333.33	-3,33,333.33
Value of Manutech Shares at the end of the Year	1,66,666.67	1,81,666.67	1,96,666.67
No. of shares outstanding under proposed arrangement	3,334	3,334	3,334
Value per share under proposed Financial Arrangement	49.99	54.49	58.99

We find that

Particulars	Scenarios (Amount in $)
	Recession	Expected	Expansion
Value of Each Share at present	51	52.5	54
Value per share under proposed Financial Arrangement	49.99	54.49	58.99
New value per share created under proposed arrangement	(0.01)	1.99	4.99

Olivia's proposed financial arrangement will increase the shareholder value in the expected and Expansion scenario. It will slightly reduce the value in case of recession.

• At present, the company is fully equity financed. It doesnot require to repay any amount to the outsiders.
• Debt financing increases the break-even point of the Company. In difficult times, it may even lead to insolvency, as the company might not be able to repay the debt due and interest when there are losses.
• Even in bad times, the fully equity financed company will be able to sustain the losses, and there won't be any risk of insolvency. Thus the owners will have the choice to shut down the business (not the compulsion) or to carry it on.
• Thus, in the proposed financial arrangement, the company will become riskier.