ABC Ltd is a mid-sized company with few investment opportunities. Earnings are stable and there is little excitement around the business of the company. The company is unlevered—it has no debt. The number of shares, issued and paid up, are 100 million, each priced at ₹50. Some of the more informed shareholders are turning restive and want the company to take a fresh look at its capital structure. They feel the company is not taking advantage of the borrowing potential to enhance its value. There is an increasing clamour to borrow substantial amounts—up to ₹2.50 billion as some shareholders demanded—and return it to the shareholders either as a special dividend or a stock buyback. The CFO of the company is taking a hard look at the options before him/her. He/she realizes that he/she is paying a tax on profits at 30 per cent, some of which could be saved if the company were to borrow funds. He/she starts asking himself/herself some questions. 

Question

1. What are the tax consequences of recapitalization? 

2. What is the value of the company today? What is the likely valuation after the recapitalization? 

3. How much will be the value of debt and of equity? Who loses out and who gains consequent to the recapitalization? 

4. Should the company pay a special dividend or repurchase equity? What considerations weigh in the decision? 

5. If the company borrows ₹1.50 billion and uses it to repurchase shares, what are the implications for shareholders? At what price should the company purchase its shares?