Capital Restructuring - Please help me!

Hi everybody, I am new here and forgive if I am posting this in the wrong section. I really need help with something. I am doing poorly in my business finance module and the teachers are unwilling to help - they don’t even respond to emails :confused: Anyway I was hoping an expert from here could help me understand this questions:

Prestamo plc generates net operating cash flows of £10 million per year before tax and is expected to continue to do so. Its capital structure consists of

(i) 10 million fully paid ordinary shares (ii) perpetual debt with a market value of £20 million in respect of which annual pre-tax interest payments of £1 million are made.

The company maintains a policy of paying 100% of its post tax profits as a single dividend each year. The after tax cost of equity of Prestamo plc is currently 12% and its ungeared after tax cost of equity is estimated to be 10%.

Company profits are subject to a corporate tax rate of 30%. It may be assumed that Prestamo plc’s taxable profits are equal to its net operating cash flows less debt interest and that corporation tax is paid in the year in which it is incurred. Shareholders are not subject to income tax in respect of dividends received but interest received is taxed at the rate of 20%. There is no capital gains tax.

The company is considering the possibility of buying back share capital with a market value of £20 million and making an additional issue of perpetual debt of £20 million. The directors of Prestamo plc wish to consider the likely effect on the existing shareholders of this possible change in capital structure. Their advisers have estimated that, in order to raise this additional debt of £20m, a pre-tax interest rate of 7% will have to be offered and that the issue would result in the company’s cost of equity rising to 18%. The advisers have assumed that the new issue would not affect the value of the existing debt which would rank above the new debt in a liquidation. a. Calculate, based on the estimates and assumptions made by the advisers, of the total market value, share price and earnings per share of the company both before and after the proposed restructuring. Using these figures, recommend whether Prestamo plc should go ahead with the proposed restructuring. b. A comparison of the results obtained in (a) with those that might have been obtained from the application of Miller’s theoretical model of the value of a geared firm in the presence of both corporate and personal taxation. Suggest possible reasons for the difference between the two sets of results. c. Recommendations as to what further information the directors ought to obtain in order to assist them in their deliberations regarding capital structure and any comment that you may have on the assumptions made by the advisers. Could someone please help me? I did the first bit: MV of Equity + MV od Debt = Total Market Value MV Debt = £20m MV Equity = EAIT/After tax cost of equity -> £6.3m/0.12 = £52.5m Total MV = 72.5m Share Price = 52.5m/10m shares = £5.25 per share Earnings per share = 6.3m/10m shares = £0.63 per share I would be so grateful if somebody could help me with the rest. : So frustrated with this stuff :’(


Somebody please help me. Please?

MV(levered) = MV(unlevered) + tax.debt step 1 - calculate value of company in unlevered state ungeared cost of equity = 10% 10m/0.1 = 100m = ungeared firm value add on tax shield MV = 100m + 20m * 0.3 = 106m [question a, total market value] 106m - 20m / 10m = 8.6 [question a, justified share price] EBIT = 10m EBT = 9m Net Income = 9m * ( 1 - 0.3) = 6.3m EPS = 6.3m / 10m = 0.63 [question a, EPS] 0.63 / 0.12 = 5.25 [question a, market price of shares] now restructure… 100m + 20m * 0.3 + 20m * 0.3 = 112m [question 1, total market value with added debt] assume, you bought back 20m/5.25 = 3.8m shares in the market, so number of outstanding shares is now 6.2m 112m - 40m / 6.2 = 11.6 [new justified share price] new EBT = 10m - 1m - (20m * 0.07) = 7.6m new Net Income = 7.6m * ( 1 - 0.3) = 5.32m new EPS = 5.32 / 6.2 = 0.858 new Market price = 0.858 / 0.18 = 4.76 so on this basis the restructuring should not go ahead. question b) you can see there is a big difference between market price of shares and justified price 5.25-8.6, 4.76-11.6 Could be macroeconomic reasons (inflation, growth), probably the answer is bankrupcy costs, but it seems a bit odd. question c) 12%->18% is probably a bad assumption. If you assume the share price doesn’t move then that gives you 0.858/5.25 = 16.3%. Since share price should rise, then 16% is probably a better estimate of the new cost of equity. My comment would be to do a management buyout, since the new debt is cheaper than existing debt and there is a tax shelter and no dividend taxes.

Thank you! Thank you so much for your answer, I am truly most grateful :slight_smile: