Effect Of Debt Issuance On Stock Valuation Resources
Effect of Debt Issuance on Stock Valuation Resources: Corporate Finance Scenario
Hightower, Inc. plans to issue $2.0 million of perpetual debt with a coupon rate of 5%, using the proceeds to repurchase common stock. The company's current valuation is $7.5 million with 400,000 shares outstanding, and it generates annual pretax earnings of $1.5 million, expected to remain constant in perpetuity. The corporate tax rate is 35%. This memo assesses the financial implications of the debt issuance, including the immediate effect on stock price after the repurchase announcement, the number of shares repurchased, and the remaining shares outstanding.
Financial Overview and Initial Valuation
Hightower, Inc. is currently an all-equity firm valued at $7.5 million with 400,000 shares outstanding, giving a current stock price of:
Current stock price = Total value / Shares outstanding = $7,500,000 / 400,000 = $18.75 per share
The firm generates $1.5 million in pretax earnings annually, which remains constant indefinitely. The firm's current value is derived from its earnings and the overall cost of equity, assuming no debt. Using the perpetual growth model, the before-tax cost of equity (approximate) can be inferred, but more relevant for valuation is the firm's enterprise value, which remains constant for an all-equity firm.
Impact of Debt Issuance and Stock Repurchase
1. Calculation of the Number of Shares Repurchased
The firm will leverage its capital structure by issuing $2.0 million of debt at a 5% coupon rate, which will sell at par. The annual interest expense will be:
Interest expense = $2,000,000 × 5% = $100,000
After issuing debt, Hightower will use the proceeds to repurchase stock at the current price of $18.75 per share, assuming the market price remains unchanged immediately after the announcement. The number of shares repurchased will be:
Number of shares repurchased = $2,000,000 / $18.75 ≈ 106,667 shares
Remaining shares outstanding after repurchase will be:
Remaining shares = 400,000 - 106,667 ≈ 293,333 shares
2. Immediate Effect on Stock Price
The announcement of a share repurchase typically signals management's confidence and can influence stock prices. Under the Modigliani-Miller framework with taxes, the leverage can increase the firm's value due to the tax shield offered by debt, leading to an increase in stock price.
To estimate the new stock price immediately after the repurchase, we need to evaluate the firm's value after debt issuance, considering the tax advantage of debt. The firm's new enterprise value (V_L) with debt is:
V_L = V_U + Tax shield
where V_U is the unlevered firm value ($7.5 million), and the tax shield is:
Tax shield = Debt × Tax rate = $2,000,000 × 35% = $700,000
Thus, the leveraged firm value is:
V_L = $7,500,000 + $700,000 = $8,200,000
Assuming market efficiency, the value attributable to equity after leverage is:
Value of equity = Total firm value - Debt = $8,200,000 - $2,000,000 = $6,200,000
The new stock price immediately after the transaction is:
New stock price = Equity value / Remaining shares = $6,200,000 / 293,333 ≈ $21.13 per share
Conclusion and Recommendations
The issuance of debt to repurchase shares will increase Hightower's leverage, thereby enhancing the company's valuation due to the tax shield benefits. The immediate effect is an increase in stock price from $18.75 to approximately $21.13 per share, reflecting the firm's increased value after debt financing and stock repurchase. The firm will repurchase about 106,667 shares, leaving approximately 293,333 shares outstanding, which may further influence stock prices and investor perception.
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