The purpose of this assignment is to demonstrate to students how the issuance of debt to purchase outstanding common stock could affect the value of the company’s equity and redefine the capital structure. The problem will also allow students to explore the effect of corporate taxes through debt financing.
Scenario: Hightower, Inc. plans to announce it will issue $2.0 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 5%. Hightower, Inc. is currently an all-equity company worth $7.5 million with 400,000 shares of common stock outstanding. After the sale of the bonds, the company will maintain the new capital structure indefinitely. The company currently generates annual pretax earnings of $1.5 million. This level of earnings is expected to remain constant in perpetuity. The tax rate is 35%.
Prepare a 200 word memo advising the management of Hightower, Inc. on the financial impact, including the following:
What is the expected return on the company’s equity before the announcement of the debt issue?
How many shares of common stock will remain after the repurchase?