Wally's Widgets International (WWI)is the world's largest manufacturer of widgets.At the end of the current year,analysts expect WWI's EBIT to be $2M and they expect the same earnings annually in perpetuity.WWI's shareholders require a return of 10% and there are 5M common shares outstanding.WWI has debt with a total face value of $5M.The bonds have an annual coupon of 5%,are rated AAA and yield 5%.The CFO of WWI believes that the company is under-levered.To increase the leverage,the CFO proposes to repurchase 1M shares at a price of $1.50 per share.The repurchase will be financed by additional borrowing.The corporate tax rate is 40%.What is the value of the company prior to the repurchase,and what is the stock price after the repurchase?
A) Value (prior) = $14M; Stock price (after) = $2.03
B) Value (prior) = $12M; Stock price (after) = $2.03
C) Value (prior) = $14M; Stock price (after) = $1.62
D) Value (prior) = $12M; Stock price (after) = $1.62
E) Value (prior) = $14M; Stock price (after) = $3.65

Question

Quizplus · Accepted Answer

This solution uses Modigliani & Miller Proposition I with taxes. V_U = 11ea7fdb_fc64_c897_a768_4384efe7afe8_TB2902_11 V_U = 11ea7fdb_fc64_c898_a768_a5946b3127aa_TB2902_11 = $12M Prior to the repurchase Wally has $5M of debt outstanding. V_L = $12M + 0.40 × $5M = $14M After the repurchase, the debt will increase to $6.5B ($5B + $1.5B) and the value of the levered firm will be: V_L = V_U + T × D V_L = $12M + 0.40 × $6.5M = $14.6M The value of levered equity after the repurchase is: E_L = V_L - D E_L = $14.6M - $6.5M = $8.1M The stock price is after the repurchase is: Price = 11ea7fdb_fc64_c899_a768_5b178a397849_TB2902_11 Solve for the number of shares outstanding, N_A N_A = N_B - N_R N_A = 5M - 1M = 4M Therefore, the stock price after the repurchase is: Price = 11ea7fdb_fc64_c89a_a768_618a8d714279_TB2902_11 = $2.025 or $2.03

Wally's Widgets International (WWI)is the World's Largest Manufacturer of Widgets