The directors of a public company are not convinced that they should follow a
consultant’s recommendation to buy back equity. The company has
insufficient cash to finance the buy back and therefore debt funds would have
to be raised to implement the recommendation. The consultants provided a
simplified commencing balance sheet (before the buy back) to illustrate what
the value of the strategy would be to shareholders wealth.
Assets $200,000 Equity $200,000
(200,000 $1 ordinary share)
The following additional information is supplied:
• Tax rate is 40%
• Interest rate on debt is 10%
• Earnings before interest and tax is 15%
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• The debt to equity ratio is to be 1:1 in the new structure
• The market value of a share is $1
The revised balance sheet will be as follows:
Assets $200,000 Debt $100,000
Equity $100,000
$200,000 $200,000
Required
Use the above example to illustrate the quantitative advantages to existing
shareholders of a buy back arrangement.
Without Debt
EAIT = $18,000/$200,000 = 9c EPS
With Debt
$200,000@15% = $30,000 EBIT
($10,000) Interest
$20,000
($8,000) Tax
$12,000 EAIT/$100,000 = 12 c EPS
Benefit from Debt = 3c per share