Question

Company "Boats" Ltd. has no debt and its total market value is $ 2M. The profit before interest and tax (EBIT) is expected to be either $50,000 during a recession, $150,000 during normal times, and $300,000 in an expansion period. "Boats" is considering issuing $500K debt at 4% interest. With the amount raised, the company intends to buy back shares from the public. There are currently 50,000 shares outstanding. Ignore taxes and assume that EPS is paid as a dividend to shareholders.

A. Calculate the Company's earnings per share (EPS) under each of the three possible states of the economy, both before and after the issuance of the debt.

B. Assuming that the probability of ending up in a recession or expansion is each 25% and the probability of ending up in normal times is 50%, what is the return on equity capital if the firm decides to take on debt? What is the WACC in such a situation?

C. Mr. Smith had planned to buy 200 shares of “Boats” when it was an all-equity firm; however, in the meantime, the company issued debt and Mr. Smith does not want to bear the added risk. What can Mr. Smith do in order to receive the same payoff as he would have received if Boats was still an all-equity firm? Provide complete numerical calculation and show that payoff is the same.

Answer 1

A.	Before issuing Debt
	Recession	Normal Times	Expansion
EBIT	50000	150000	300000
Less Interest	0	0	0
Earnig Before Tax	50000	150000	300000
Less : Tax (ignore)	0	0	0
Earning After Tax(A)	50000	150000	300000
No. Of Outstanding Share(B)	50000	50000	50000
Earning Per Share (A/B)	1	3	6
Market Value of Boats( c)	2000000	2000000	2000000
Per Share Value(C/B)	40	40	40
Shares buy Back(D)	12500	12500	12500
(500000/40)
Shares after buyback(B-D)	37500	37500	37500
	After issuing Debt
	Recession	Normal Times	Expansion
EBIT	50000	150000	300000
Less Interest	20000	20000	20000
Earnig Before Tax	30000	130000	280000
Less : Tax (ignore)	0	0	0
Earning After Tax(A)	30000	130000	280000
No. Of Outstanding Share(B)	37500	37500	37500
Earning Per Share (A/B)	0.8	3.47	7.47
B.
Return on Equity after taking debt
(Dividend/Marketprice*100)(a)	2%	9%	19%
Probability(b)	25%	50%	25%
(a*b)	0.500%	4.333%	4.667%
Return of Probability	9.500%
WACC	Source	Amount	Weight	Return	Return*Weight
	Equity	1500000	0.75	9.500%	7.125
	Debt	500000	0.25	4%	1
		2000000			8.125
		WACC = 8.125%
C)
Return on Equity before taking debt
(Dividend/Marketprice*100)(a)	3%	8%	15%
Probability(b)	25%	50%	25%
(a*b)	0.625%	3.750%	3.750%
	Return	8.125%
	If Mr Smith Bought in all equity Return would be	650
	If Mr Smith Bought in all equity Return would be	760
	In order to get same return he should buy	171.0526316	Shares