A.G corporation is entirely financed by common stock and has a beta of 1.0 , Firm pays no taxes , The stock has a price-earnings multiple of 10 and is priced to offer a 10% expected return. The company decides to restructure and repurchase half of its stock with a substitute debt.If debt yields 5% calculate (a) beta of the common stock before and after the restructuring (b) the percentage increase is earnings per share © new price-earnings multiple. (has anything happend to stock price)
I am not sure of the solution - I have not covered this stuff yet, but i would like to take a guess. First, I would apply some numbers to the information given: assume current stock price is $100., so if P/E is 10, then EPS is $10. assume 1,000,000 shares common stock in play so net earnings is $10,000,000 and market cap is $100,000,000. So, company issues $50,000,000 in debt to buy back .5 of its shares. Stock outstanding is now 500,000. net earning reduced by interest expense of $2,500,000 so now is $7,500,000. This results in EPS of 15 and p/e (if price is unchanged) of 6.666. EPS increased by 50 percent. Beta is given at 1 before. After we can use the “pure-play” method to see what happens to the beta after debt. leveraged beta = Beta(unlevered) *[1+{(1-t)*d/e}] beta unlevered = 1, 1-t = 1, d/e = 1, so 1 * 2 = new beta of 2. I’m not sure how to adjust p/e multiple maybe someone can add to my thoughts and correct my assumptions or provide a better way to tackle this problem.
hei los_cfa08 i think you got it right mate but i can u explain me this pure-play method coz its really new to me tks alot mate *thumbs up*
The new beta willl be: 1*[1+(1-0)(1)]=2 I’d agree with los’s explanation on the PE and EPS.
do a 10% expected return have any bearing on EPS going forward?
Nope. I don’t think it’ll affecct the EPS. The 10% required return is needed only to determine the per share price, which is not what you need in computign EPS
90% increase in EPS? 5.26 new P/E?