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TAP is currently an all-equity firm. It expects to generate earnings before interest and taxes (EBIT) of $15 million over the next year. Currently, TAP has 12 million shares outstanding, and its stock is trading for a price of $6.00 per share. TAP is considering changing its capital structure by borrowing $24 million at an interest rate of 5% and using the proceeds to repurchase 4 million shares at $6.00 per share. Suppose TAP has no debt and there are no interest and no taxes. (7 marks)What would TAP’s earnings per share be without leverage? (2 marks)Calculate TAP’s earnings per share after recapitalization (2 marks)Assume TAP’s EBIT is not expected to grow in the future and all earnings are paid as dividends. Use MM proposition to show that the increase in expected EPS for TAP will not lead to an increase in the share price. (3 marks)

Question

TAP is currently an all-equity firm. It expects to generate earnings before interest and taxes (EBIT) of 15millionoverthenextyear.Currently,TAPhas12millionsharesoutstanding,anditsstockistradingforapriceof15 million over the next year. Currently, TAP has 12 million shares outstanding, and its stock is trading for a price of 6.00 per share. TAP is considering changing its capital structure by borrowing 24millionataninterestrateof524 million at an interest rate of 5% and using the proceeds to repurchase 4 million shares at 6.00 per share. Suppose TAP has no debt and there are no interest and no taxes. (7 marks)What would TAP’s earnings per share be without leverage? (2 marks)Calculate TAP’s earnings per share after recapitalization (2 marks)Assume TAP’s EBIT is not expected to grow in the future and all earnings are paid as dividends. Use MM proposition to show that the increase in expected EPS for TAP will not lead to an increase in the share price. (3 marks)

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Solution

Sure, let's break down the question and answer it step by step.

  1. What would TAP’s earnings per share be without leverage?

Earnings per share (EPS) is calculated by dividing the earnings (EBIT in this case as there are no interest and taxes) by the number of shares outstanding.

So, EPS = EBIT / Number of shares = 15million/12millionshares=15 million / 12 million shares = 1.25 per share

  1. Calculate TAP’s earnings per share after recapitalization

After recapitalization, TAP borrows 24millionataninterestrateof524 million at an interest rate of 5%, so the interest expense would be 24 million * 5% = $1.2 million.

The new EBIT after interest would be 15million−15 million - 1.2 million = $13.8 million.

Also, TAP repurchases 4 million shares, so the new number of shares outstanding would be 12 million - 4 million = 8 million shares.

So, the new EPS = New EBIT / New number of shares = 13.8million/8millionshares=13.8 million / 8 million shares = 1.725 per share

  1. Use MM proposition to show that the increase in expected EPS for TAP will not lead to an increase in the share price.

According to Modigliani-Miller (MM) theorem, in a world without taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.

Even though the EPS increases after recapitalization, the increase in EPS does not increase the value of the firm or the share price. This is because the increase in EPS is exactly offset by the increase in the firm's financial risk due to the additional debt, which increases the required rate of return by shareholders. Therefore, the share price remains unchanged.

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