Question

Warsaw Manufacturing, Incorporated, plans to announce that it will issue $2.15 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 6 percent. The company is currently all-equity and worth $6.62 million with 198,000 shares of common stock outstanding. After the sale of the bonds, the company will maintain the new capital structure indefinitely. The annual pretax earnings of $1.39 million are expected to remain constant in perpetuity. The tax rate is 22 percent.

a. What is the expected return on the company’s equity before the announcement of the debt issue? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
b. What is the price per share of the company's equity? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
d. What is the company’s stock price per share immediately after the repurchase announcement? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
e-1. How many shares will the company repurchase as a result of the debt issue? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
e-2. How many shares of common stock will remain after the repurchase? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
g. What is the required return on the company’s equity after the restructuring? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

The expected return on the company's equity before the announcement of the debt issue is 28.23%. The price per share of the company's equity is $22.56. The company's stock price per share remains $22.56 after the repurchase announcement.

Step-by-step explanation:

To determine the expected return on the company's equity before the announcement of the debt issue, we need to calculate the current value of the equity. The company is all-equity, so the value of the equity is the same as the total firm value. Using the formula:

Equity value = Total firm value - Debt

Equity value = $6.62 million - $2.15 million = $4.47 million

The expected return on equity can be calculated using the formula:

Expected Return on Equity = (Annual Pretax Earnings - Debt Interest Expense) / Equity Value

The Annual Pretax Earnings is $1.39 million, and the Debt Interest Expense can be calculated as the Debt multiplied by the Coupon Rate:

Debt Interest Expense = $2.15 million * 6% = $0.129 million

Substituting the values into the formula, we get:

Expected Return on Equity = ($1.39 million - $0.129 million) / $4.47 million

Expected Return on Equity = $1.261 million / $4.47 million

Expected Return on Equity = 0.2823 or 28.23%

Therefore, the expected return on the company's equity before the announcement of the debt issue is 28.23%.

To determine the price per share of the company's equity, we divide the equity value by the number of shares:

Price per Share = Equity Value / Number of Shares

Price per Share = $4.47 million / 198,000 shares

Price per Share = $22.56

Therefore, the price per share of the company's equity is $22.56.

The company's stock price per share immediately after the repurchase announcement will remain the same as before the announcement because the repurchase does not affect the firm's value or the number of shares outstanding.

Therefore, the stock price per share remains $22.56.

The number of shares repurchased as a result of the debt issue can be determined by dividing the proceeds from the debt issue by the stock price per share:

Number of Shares Repurchased = Proceeds from Debt Issue / Price per Share

Number of Shares Repurchased = $2.15 million / $22.56

Number of Shares Repurchased = 95,238.10 or 95,238 shares

The number of shares of common stock remaining after the repurchase can be calculated by subtracting the number of shares repurchased from the initial number of shares:

Number of Shares Remaining = Initial Number of Shares - Number of Shares Repurchased

Number of Shares Remaining = 198,000 shares - 95,238 shares

Number of Shares Remaining = 102,762 shares

Therefore, the company will repurchase 95,238 shares and have 102,762 shares of common stock remaining after the repurchase.

The required return on the company's equity after the restructuring remains the same as before the announcement, as the restructuring did not affect the company's financial position or risk. Therefore, the required return on the company's equity remains 28.23%.