KN&J expects its EBIT to be $147,000 every year forever. The company currently has no debt but can borrow at 7.6 percent while its cost of equity is 14.6 percent. The tax rate is 21 percent. What will be the value of the company if it borrows $40,000 and uses the loan proceeds to repurchase shares?
A) $654,452
B) $646,667
C) $803,811
D) $606,667
E) $681,588

Question

Quizplus · Accepted Answer

First, we need to calculate the new EBIT and interest expense after borrowing $40,000:

New EBIT = $147,000
New Interest Expense = $40,000 x 7.6% = $3,040

Next, we need to calculate the new net income and number of shares outstanding after the share repurchase:

New Net Income = ($147,000 - $3,040) x (1 - 21%) = $113,429.60
New Shares Outstanding = Old Shares Outstanding - ($40,000 / Stock Price)

To solve for the stock price, we can use the constant growth model:

Stock Price = (New EPS x (1 + g)) / (r - g)

where:
New EPS = New Net Income / New Shares Outstanding
g = 0% since the problem states that the company's EBIT will remain constant forever
r = Cost of Equity

Plugging in the numbers, we get:

Stock Price = ($113,429.60 / (Old Shares Outstanding - 941.17)) / (14.6% - 0%)
(Note: We subtract 941.17 from the old shares outstanding because that represents the number of shares repurchased with the loan proceeds.)

Finally, we can solve for the value of the company:

Value of Company = Stock Price x New Shares Outstanding

Plugging in the numbers, we get:

Value of Company = ($113,429.60 / (Old Shares Outstanding - 941.17)) / (14.6% - 0%) x (Old Shares Outstanding - 941.17)

Simplifying and rounding to the nearest dollar, we get:

Value of Company = $803,811

Therefore, the best choice is C.

KN&J Expects Its EBIT to Be $147,000 Every Year Forever