Question

(sorry but this is all information i have)

A company is financed entirely through common stock and has a beta of 1.0. The stock has a P/E ratio of 10.0 and is priced to offer a 10% return. The company plans to issue debt and repurchase half the shares. The debt has a risk-free rate of 5% per annum. The company pays no taxes. EBIT remains constant before and after the issuance of debt and share repurchase. Calculate the following:

(a) The beta of the common stock after the refinancing.

(b) The required return and the risk premium on the common stock before the refinancing?

(c) The required return and the risk premium on the common stock after the refinancing?

(d) The required return on the debt.

(e) The required return on the company (i.e., both debt and equity) after the refinancing.

(f) The increase in EPS after the refinancing.

(g) The new P/E ratio after the refinancing.

Answer 1

A company Some values below may show as rounded for display purposes, though unrounded numbers should be used for the actual calculations Currently, with no outstanding debt, pequity 1. Therefore: Bassets 1 Also: requ ity : 10.0% rassets 10.0% Finally: rdebt-5.0% The firm plans to refinance, resulting in a debt-to-equity ratio of 1 and a debt-to-value ratio of debi/(cle.bi: qu iiy) : : (.%. (a) The beta of the common stock after the refinancing (Bequity x 0.5) +0 1 Bequity 1/0.5 2 (b) The required return and the risk premium on the common stock before the refinancing? requity : rassets-10.0% Risk premium-requity-rdebt 10.0%-5.0%-5.0% (Note that the debt is risk-free.) (c) The required return and the risk premium on the common stock after the refinancing? requity-rassets + [D/EX (rassets-rdebt)]-10.0% + [1 x (10.0%-5.0%)-15.0% Risk premium-requity-rdebt 15.0%-5.0%-10.0% (d) The required return on the debt. Required return 5.0 %

(e) The required return on the company (i.e., both debt and equity) after the refinancing. rassets (0.5 x requity) + (0.5 x rdebt-(0.5 x 15.0%) + (0.5 x 5.0%-10.0% This is unchanged. (f) The increase in EPS after the refinancing. Suppose total equity before the refinancing was $1,000. Then expected earnings were 10.0% of $1,000, or $100. After the refinancing, there will be $500 of debt and $500 of equity, so interest expense will be $25.0. Therefore, earnings fall from $100 to $75, but the number of shares is now only half as large. Therefore, EPS increases by 50% EPS after/EPS before (85/500)/100/1000- 1.50 e) The new P/E ratio after the refinancing. The stock price is unchanged, but earnings per share have increased by a factor of 1.50. Therefore, the P/E ratio must decrease by a factor of 1.55, from 10.0 to: 10.0/1.50 6.67 So, while expected earnings per share increase, the earnings multiple decreases, and the stock price is unchanged.