Question

SMPrime Holdings is a closely held corporation with a capital structure composed entirely of common stock and retained earnings. The stockholders have an agreement with the company that states the company will purchase the stock of a shareholder should a shareholder want to sell his or her holdings in the company. The agreement states that the stock will be purchased at a price equal to the stock's previous year-end book value per share. Early in October 2017, Mrs Bean, a widow of one of SM Prime's major stockholders expressed an interest in selling her stock in accordance with the buy-back pricing agreement. Mrs Bean owns 600,0000 shares of the 3 million shares of SM Prime's common stock. The Board of Directors has concluded that the company must replace the capital used to repurchase the shares. The board has assurances that it would be to finance the acquisition of stocks by borrowing the necessary funds on 10-year notes through private placement at an annual interest rate of 10 percent. Thus the company would have capital provided by debts and perhaps be able to take advantage of financial leverage. The Board and Mrs Bean agreed that the exchange will take place on January 01, 2018. The book value per share of common stock is projected to be P50 on December 31, 2017. The comptroller of SM Prime Holdings had prepared a forecast and pro forma statements for the year 2018. An excerpt of the forecasted earnings statement for the year ended December 31, 2018 is presented below (in thousands of pesos). SM Prime used a 40 percent income tax rate in the forecasted statement. The pro forma statements do not reflect the repurchase of Mrs. Bean's shares or the new issue of debt required to pay for the shares. P50,000 20.000 30,000 Income before interest and taxes Less: Income taxes @40% Net Income ======= Answer the following requirements 1. Revised the excerpt from SM Prime Holdings' forecasted earnings statement for the year ended December 31, 2018 to reflect the long-term debt financing to be used the purchase Mrs Bean's common stock. Assume the 40 percent tax rate will still be applicable. 2. Explain the impact of long-term debt financing would have on SM Prime Holdings' earnings per share (EPS) and return on stockholders' equity (RCOE) using the forecasted data for 2018. 3. Identify and discuss the advantages and disadvantages of financial leverage fo a company that has a capital structure similar to that of SM Prime Holdings before and after this long-term debt has been added.

Answer 1

Part (1)

New Debt = Number of shares repurchased x Repurchase price = 600,000 x 50 =  30,000,000

interest rate = 10%

Hence, interest expense = 10% x 30,000,000 = 3,000,000

New proforma will be like this (Financials are in '000)

Financials	('000P)
Income before interest & taxes	50,000
[-] Interest	3,000
Earnings before taxes	47,000
[-] Taxes at 40%	18,800
Net Income	28,200

Part 2)

Number of shares outstanding after the repurchase = 3,000,000 - 600,000 = 2,400,000

Book value of Equity before repurchase = Book value per share x number of shares = 50 x 3,000,000 = 150,000,000

Book value of Equity before repurchase = Book value per share x number of shares = 50 x 2,400,000 = 120,000,000

Please see the table below for EPS and ROE calculation before and after repurchase. Please note that financials are in ('000P) and number of shares are in ('000). Please be guided by the second column titled “Linkage” to understand the mathematics.

Parameters	Linkage	Before repurchase ('000P)	After repurchase ('000P)
Income before interest & taxes	A	50,000	50,000
[-] Interest	B	-	3,000
Earnings before taxes	C = A - B	50,000	47,000
[-] Taxes at 40%	D = C x 40%	20,000	18,800
Net Income	E = C - D	30,000	28,200
Book Value of equity	F	150,000	120,000
Number of shares outstanding ('000)	G	3,000	2,400
EPS	H = E / G	10.00	11.75
ROE	I = E / F	20.00%	23.50%

Both the parameters, EPS and ROE increase after share repurchase. Thus, long term debt financing will increase the EPS as well as ROE. Leverage with controlled limits, do help improve EPS as well as ROE.

Part (3)

Before adding long term debt:

• The firm is fully unlevered and an all equity firm.
• The advantage is there is no mandatory interest obligation or repayment obligation on the company
• Company is better prepared to absorb fluctuations and volatility in business as degree of leverage is zero
• The disadvantage is: EPS and ROE remain suppressed

After adding the long term debt:

• The capital structure now is D / E = 30 / 120 = 0.25; Debt to total capital = 30 / (30 + 120) = 20% and proportion of equity is 80%
• Such a leverage within controlled limits bring in interest which are tax deductible. The firm gets an interest tax shield.
• Controlled leverage improves EPS and ROE (we have seen this in part (b))
• Controlled leverage brings down the overall cost of funds as debt is cheaper than equity. This help improve the value of the firm.
• Disadvantage is that the firm now has a mandatory obligation of interest and repayments. Degree of financial leverage has gone up and hence a firm may see pressure in case earnings decline due to any adverse reason.