Q5 Question 5

Answer the following parts independently of each other.

Q5.1 Question 5.1

12 Points

The finance manager of the GZA Ltd is considering a recapitalization plan that would convert GZA from its current all-equity capital structure to one including substantial financial leverage. GZA now has 10,000,000 ordinary shares outstanding, which are selling for $15 each, and the companys EBIT is expected to be $12,000,000 per year for the foreseeable future. The recapitalization proposal is to issue $60,000,000 worth of long-term, perpetual debt at an annual interest rate of 3.0% and use the proceeds to repurchase 4,000,000 ordinary shares worth $60,000,000. Assume perfect capital markets with no market frictions such as corporate or personal income taxes.

5.1.1. Calculate the earnings per share and expected return on equity for GZAs shareholders under both the current all-equity capital structure and under the recapitalization plan. Show all calculations.

5.1.2. Calculate the breakeven level of EBIT where the earnings per share are the same under the current and proposed capital structures. Show all calculations.

Q5.2 Question 5.2

5 Points

HZA Ltd has $100 million of perpetual debt outstanding with a cost of debt of 9% p.a. which is expected to remain unchanged. The company is currently subject to a corporate tax rate of 30%. Following national elections, the incoming government unexpectedly passes a law that increases the corporate tax rate for all companies to 35%. Assuming perfect capital markets with positive corporate taxes, what will be the most likely immediate change in the market value of the company? Show all calculations.