SuperOil has a debt-to-value ratio of 15%. Its revenue is 100,000 per year and cost is 70,000 per year forever. Its cost of debt is 7% and its cost of equity is 25%. It has 10,000 shares outstanding. Corporate tax rate is 35%. (a) What is the firm’s value?
(b) What is its stock price?
(c) SuperBuyout is a leveraged buyout firm. It believes that SuperOil’s leverage is too low. It thinks that SuperOil’s firm value can increase with higher debt-to-value ratio and believes SuperOil’s optimal debt-to-value ratio is 25%. SuperOil’s cost of debt at this 25% debt-to-value ratio is 9%. SuperBuyout is considering buying all of SuperOil’s shares and increase SuperOil’s leverage to the optimal 25% level. Proceed from debt issuance will be given out to equityholderes as special dividend. What is the maximum premium SuperBuyout is willing to pay for SuperOil’s shares?

a. The firm’s value is $88,909

b. The stock price is $7.56

c. The maximum premium SuperBuyout is willing to pay for SuperOil’s shares is $3,200

Explanation:

a. In order to calculate the firm’s value we would have to calculate the following calculation:

firm’s value=EBIT*(1-Tax rate)/WACC

EBIT*(1-Tax rate)=($100,000-$70,000)*(1-0.35)

EBIT*(1-Tax rate)=$19,500

WACC=weight of debt*cost of debt(1-t)+weight of equity*cost of equity

WACC=0.15*7*(1-0.35)+0.85*25

WACC=21.9325%

Therefore, firm’s value=$19,500/21.9325%

firm’s value=$88,909

b. In order to calculate its stock price we would have to calculate the following calculation:

stock price=Equity value/number of shares

Equity value=0.85*$88,909

Equity value=$75,572

Therefore, stock price=$75,572/10,000

stock price=$7.56

c. In order to calculate the maximum premium SuperBuyout is willing to pay for SuperOil’s shares we would have to make the following calculation:

maximum premium SuperBuyout is willing to pay=(stock price-value per share)*number of shares

maximum premium SuperBuyout is willing to pay=($7.56-$7.24)*10,000

maximum premium SuperBuyout is willing to pay=$3,200

answer: in the short-run firms will respond by raising the price of turkey.

explanation: initially the long-run equilibrium is at a price of $5 per pound of turkey and a quantity of 50 million pounds per year. now, when webmd claims that a protein found in turkey will increase your expected lifespan by 4 years. the consumers demand for turkey will increase at every price shifting the demand curve to the right from d1 to d2. while, there will be no change in the supply curve in the short-run as it is not possible for producers to adjust supply so quickly. as a result the new equilibrium will occur at a higher price and a higher quantity of turkey.

thus, in the short run firms will respond by increasing the price of turkey, selling more quantity at a higher price and earning economic profits.