Reference no: EM13651080
Case Study 1: Imperial Sandwich Plc
Imperial Sandwich Plc is to be established shortly. The founders are considering their options with regard to capital structure. A total of £5 m will be needed to establish the business and the two ways of raising these funds being considered here are:
a) Selling 1 million shares at £5.00
b) Selling 500,000 shares at £5.00 and borrowing £2.5 million with an interest rate of 10%.
The company plans to pay out the total net income as dividends to the shareholders. The possible outcome for the future EBIT is £750,000. The corporate tax rate is 40%.
The founders has analyzed a proxy company and found it to have a beta of 1.2 and a market debt-equity ratio of 0.5. The risk-free rate is 5.8% and the market premium 4.5%
a) Calculate the WACC under each of the capital structures. Comment on the result.
b) Suppose that the founders of Imperial Sandwich Plc chose an equal debt-equity capital structure and established the company sometimes ago. The company generates a certain EBIT of 900,000 in perpetuity. But now the CFO of Imperial Sandwich has proposed that the company should sell equity and buy back debt in order to maximize its value. If 250,000 shares are issued at £ 5 each, £1.250 million is collected and used to retire £1.250 million of debt. Given your understanding of modern finance theory, discuss this proposal in term of its effects on firm value, price/earnings ratio and price per share. The corporate tax rate is 40% as above and the interest rate is 10% as above.
Case Study 2. Dividends
There are no taxes. Firm A currently has 1 million shares with per-share value $40. The next dividend, $2/share, will be paid 1 year from now. Then dividends will rise by 3% the following year. Firm B has identical operations and will always have the same total $ amount of earnings. It also has the same number of shares. Also, firm B intends to pay out the same amount of cash (in total, not per-share) as firm A, but will pay out half of the cash as a repurchase, and half as a dividend that occurs just before the repurchase (i.e., the repurchase is ex-dividend). B will again distribute the same total amount of cash as A in the second year, again using half repurchase and half dividend. A and B both have 8% required return.
a) What is the per share dividend for firm B the first year?
b) How many shares will firm B repurchase at what price the first year?
c) What is the per-share dividend for firm B the second year?
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