Gammamax Company Capital Structure Firm Value Leverage Debt Tax Shield and Price Earnings Analysis Worked Finance Solution

Susan Varhard, treasurer of the Gammamax Company, has proposed that the company should sell equity and buy back debt in order to maximize its value. As evidence, she presents the financial statements given in Table Q15.9. The company currently has a price/earnings ratio of 50. Before the change in capital structure it has 10 shares outstanding; therefore its earnings per share are $ 1.00, and the price per share is $50. If 10 new shares are issued at $50 each, $500 is collected and used to retire $500 of debt (which pays a coupon rate of 8%). After the capital structure change, earnings per share have increased to $1.50 (since there are now 20 shares outstanding); with a price/ earnings ratio of 50, presumably the price per share will increase from $50 before the capital structure change to $75 afterward. Given your understanding of modem finance theory, discuss the above proposal.

Table Q15-9

SOLUTION

Varhard’s recommendation is obviously wrong. The value of the firm will decline if there is any gain to leverage. In a MM world with only corporate taxes

VL = VU + c B

Reducing leverage reduces the value of the debt tax shield. The investment decisions of the firm remain unchanged while the financing decision increases the firm’s weighted average cost of capital.

For a numerical answer, assume away the effect of growth. When growth is zero, the appropriate valuation model is