Recapitalization of Your Firm Balance Sheet and Income Statement Effects
There are two parts to this group assignment. First, you will assess the effect of a change in leverage by your firm on the book and market value balance sheets. Second, you will study the effects of changes in leverage and sales on the income statements. Use the most current accounting data from COMPUSTAT to make your estimates. Handout #10 should serve as a guide in your efforts.
The first part of the assignment is based on the example on page 502 of the textbook in Chapter 17 (An Introduction to Debt Policy and Value).
Here you will analyze the effects of recapitalizing the firm that you have been assigned using the Modigliani & Miller (1963) framework, to see the effects on the book and market value balance sheets, and on shareholder wealth.
Assume that the managers of the firm are considering doubling the amount of long-term debt outstanding.
You will need to create a condensed version of the book value balance sheet for your firm. For the longterm debt account, be sure to combine the portions listed under both current and long-term liabilities. You will probably also want to break-out the Notes Payable from the other current accounts, which is useful for estimating the value of the tax-shield. Be sure to adjust the values of the current liabilities for the removal of these two accounts. You must then develop a market value balance sheet based on the current share prices. Estimate the firm’s effective tax rate using historical data to determine the values of the tax shields.
[Use the tax rate from your estimates of WACC in Homework #4A.] Then estimate the effect of doubling the book-value of long-term debt on both balance sheets.
Consider two cases for how the funds raised in this bond issue will be used. First, assume that all of the proceeds are paid-out as a special one-time dividend to all common stock holders. In the second scenario assume that the firm uses the funds raised to buy back some of their shares.
For the second part of the assignment, you will examine the effects of changing sales and financial leverage on the firm’s income statement.
First, estimate the effects of a 20% increase and decline in sales on the most current income statement.
Assume that all of the top-line cost accounts, cost-of-goods-sold (COGS), selling, general and administrative expenses (SGA), and depreciation, vary as a percent-of-sales (in this case I suggest you use the percents-of-sales for the most recent fiscal year for consistency). Be sure to estimate Earnings per Share for the current income statement (or an amended version if you think it appropriate) and for the two scenarios with higher and lower sales (based on the current number of outstanding shares). I might suggest that you re-estimate taxes and net income using the rate you used in Homework #4A to ensure the consistency of the results.
Then estimate the effect of the firm doubling its long-term debt on the most current income statement.
Clearly,, you will need to determine an appropriate rate on the new debt. For this first projection assume that the firm will issue bonds denominated in US Dollars that will mature in 10 years. Clearly, you can use the data you have collected on bond yields from the Bloomberg Terminal in making your estimates of an appropriate yield. Estimate the Earnings-per-Share for two cases. The first where the firm issues the 10- year bonds and the funds are used to pay a one-time dividend, In the second case, the firm issues the 10- year bonds and the funds are used to repurchase shares. In both cases calculate the EPS for the current level of revenues and if sales are 20% higher and lower.
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