For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other.
Your company is considering acquiring XYZ, Inc., a biotechnology firm. XYZ, Inc. has expected annual EBIT of $1,500,000 in perpetuity, and the appropriate discount rate for the risk associated with the cash flow is 15%. XYZ is an all equity firm and has 500,000 shares outstanding. The CEO of XYZ, Inc. has a very exciting plan to make her company look more attractive to your company. She suggests to her CFO that if the firm issues $5M debt in perpetuity with a return of 10%, and uses this debt to repurchase some of the shares of the company, it will make the firm more attractive to acquirers. The CFO is sceptical of the CEO’s plan and argues with her about the logic behind it. Frustrated with her CFO’s argumentative stance, the CEO finally simply states: “I do not have to convince you, John, especially since my plan is fool proof. My debt-based strategy will make our company attractive to any acquirer because it will lower our price-earnings ratio and, consequently, make them offer us a lot more money for our assets than they would otherwise.” Assume the corporate tax rate is 35% and the interest payments on debt are tax deductible.
1. Is the CEO correct in believing that the price-earnings ratio of XYZ, Inc will drop?
Mabye
No
Yes
2. What will be the new P/E ratio of XYZ, Inc. if it adopts this new debt-enhanced strategy?
3. Is the CEO correct in concluding that your company will pay more to acquire XYZ, Inc.?
Mabye
No
Yes
4. What is the new enterprise value of XYZ, Inc.?
5. What is the return on equity of XYZ, Inc. if the proposal of the CEO to take on debt is implemented?