ABC Inc. completed its IPO one year ago and is still an all-equity firm. Kate, its CFO, found recently that the industry average debt-to-total-assets ratio is about 30%. She is considering recommending that the board of directors accept an 8% perpetual loan offered by the bank to buy back some common shares and introduce debt into ABC’s capital structure.
Currently, ABC has 10 million shares of common stock outstanding with a market capitalization of $150 million. Its earnings before interest and taxes (EBIT) are expected to be $50 million per year forever, and it pays out all the earnings available to shareholders as dividends. The corporate tax rate for ABC is 40%. Kate has asked you to provide quantitative evidence to support her recommendation by answering the following questions:
Ensure you include the following in your answer:
Calculate ABC’s current price per share, cost of equity, and weighted average cost of capital (WACC).
Calculate the dollar amount of loan that ABC should take on to increase its debt-to-total-assets ratio to the 30% industry average according to Miller & Modigliani (M&M) Propositions.
Calculate ABC’s total value of the firm (that is, the value of total assets), value of equity, cost of equity, WACC, and price per share, and the number of shares of common stock outstanding after the share repurchase. Show that ABC will reduce its WACC after this restructuring.
State another possible motive for ABC to repurchase its own shares.