Effect of Debt Issuance on Stock Valuation

The purpose of this memo is to advise management on the financial impact of the company. The memo will include the expected return on the company’s equity before the announcement of the debt issue, the company’s market value balance sheet before the announcement of the debt issue, the price per share of the firm’s equity, the company’s market value balance sheet immediately after the announcement of the debt issue, the company’s stock price per share immediately after the repurchase announcement, shares the company repurchase as a result of the debt issue, shares of common stock will remain after the repurchase, and the required return on the company’s equity after the restructuring. It will also explain the advantages and disadvantages of debt financing over equity financing.

The expected return on equity for a firm refers to the ration of annual after tax earnings to the market value of the firm’s equity. The amount the firm must pay each year will be; in the case of Hightower Inc., the expected return on the company’s equity is 13%. The taxes totaled $525,000. Therefore, the return on equity (R0) equals $1,500,000 – $525,000 divided by $7,500,000 which equals 0.13 or 13%. Hightower Inc. price per share is $27.50 and their pre-debt announcement balance sheet is listed below. Balance sheet before the announcement of debt issue is shareholder’s equity $0, equity $7.5 million, earnings $1.5 million, and total shareholder’s equity $9.0 million. The company’s stock price is $11,000,000 divided by 400,000 which equals $27.50.

The company’s market value balance sheet immediately after the announcement of the debt is prior assets $7,500,000, total debt $2,000,000, tax shield $700,000, total equity $6,200,000, and total assets $8,200,000. Equity plus debt equaled a total of $8,200,000. The company’s stock price per share immediately after the repurchase announcement $20.50. This includes a new debt amount of $2,000,000 for capital structure, new value for Hightower, Inc. of $8,200,000, equity value equals $8,200,000 minus $2,000,000 which equals $6,200,000. The price per share immediately after repurchase is $8,200,000 divided by $400,000 which equals $20.50. When $400,000 is subtracted from $97,560.9756 it equals 302,439.02439. Then $6,200,000 is divided into $302,439.02439 the sum equals $20.50. “To assess the theoretical issuance motives separately, we propose a simple framework that characterizes how issuers should design convertible debt to efficiently mitigate specific debt- and equity-related costs of external finance (Lewis, Rogalski, & Seward, 2003). 2,000,000/20.50=97560.9756 new shares purchased.

In order to figure out the repurchase we must first determine the value per share the value is $7,500,000, the outstanding shares is $400,000. Divide the value $7,500,000 into the shares outstanding $400,000 once the calculations are done the value per share is $18.75. The debt issue is $200,000 so in order to get the amount to be repurchased the company must divide the debt issue $2,000,000 into the value per share $18.75 which, gives the amount to be repurchased of $106,666.67. The amount of common stock that will remain after repurchase is the outstanding shares $400,000 divided by the amount to be repurchased $106,666.67 which, gives us a total of $293,333.33 amount of shares that will remain. The required return on the company’s equity after the reconstructing the earning must be considered. The earnings is $1,500,000 and the tax rate of 35% has to be multiplied which gives an amount of $525,000.

Once this amount is figured out the $525,000 had to be subtracted from the earning $1,500,000 and that gives the amount of $975,000. Then the company must divide that $975,000 by the amount of shares remaining to determine the required return $293,333.33 to come up with the required rate of return on the company’s equity which would be 3.32.

•The advantage of debt financing over equity financing

They weaken the ownership of the interest in the company for the owner because they are not required to claim equity in the business.

Lenders can only get the repayment of the agreed-upon principal of the loan plus interest, and cannot claim on future profits of the business.

The interest on the debt can be subtracted from the company’s tax return with debt financing.

With debt financing the company is not made to comply with the state and federal securities laws and regulation which makes raising debt capital a hassle.

The company does not have to mail anything to investors or hold meeting of shareholders or take a vote before making certain decisions.

•The disadvantages of debt financing over equity financing

The debt still has to be repaid, also the interest is a fixed cost and raises the break-even point for the company. This can be difficult for the company and cause them to have a higher debt.

Cash flow is required for both principal and interest payments and must be budgeted for.

Debt instruments often contain restrictions on the company’s activities, preventing management from pursuing alternative financing options and non-core business opportunities.

The larger a company’s debt-equity ratio, the more risky the company is considered by lenders and investors.

The company is usually required to pledge assets of the company to the lender as collateral, and owners of the company are in some cases required to personally guarantee repayment of the loan.

Now that the calculations for the expected return on the company’s equity before the announcement of the debt issue, the company’s market value balance sheet before the announcement of the debt issue, the price per share of the firm’s equity, the company’s market value balance sheet immediately after the announcement of the debt issue, the company’s stock price per share immediately after the repurchase announcement, shares the company repurchase as a result of the debt issue, shares of common stock will remain after the repurchase, and the required return on the company’s equity after the restructuring have all been provided. And the explanation of the advantages and disadvantages of debt financing over equity financing has also been provided. Management of Hightower, Inc. should be able to move forward with financial aspect of the company. Thank you for allowing Team C to work on this request. Have a wonderful day and the Team looks forward to working with Hightower, Inc., in the future.

If there are is any further clarification needed please feel free to contact Team C

Regards,

Team C (Florence Allen, Kimberly Ards, LaToya Grant-Buckson, Travis Jones)

References

Lewis, C. M., Rogalski, R. J., & Seward, J. K. (2003). Industry conditions, growth opportunities and market reactions to convertible debt financing decisions. Journal of Banking & Finance, 27(1), 153-181.

Ross, S., Westerfield, R., Jaffe, J., & Jordan, B. (2016). Corporate Finance (11th). New York, NY: McGraw-Hill.

Debt vs. Equity — Advantages and Disadvantages. (n.d.). Retrieved February 23, 2017, from http://smallbusiness.findlaw.com/business-finances/debt-vs-equity-advantages-and-disadvantages.html