Doubts

Review Quiz - Limits of Debt

Review Quiz - Limits of Debt

by Sofia Lampreia Alves Garcia -
Number of replies: 1

Hi Professor,

I'm working through the Topic 8 review quiz (Limits of Debt) and got stuck on the question about Big Blue Banana borrowing 100 million dollars to repurchase shares.

Here’s how I approached it:

  • I calculated the value of the tax shield as 100 million dollars times 35%, which gives 35 million dollars.

  • I added this to the current firm value (25 million shares × 10 dollars = 250 million), so the new firm value becomes 285 million dollars.

  • Since BBB is using the 100 million dollars of debt to buy back shares at 10 dollars each, I figured they would repurchase 10 million shares, leaving 15 million shares outstanding.

  • I then calculated the new share price as 285 million minus 100 million (to get the equity value), divided by 15 million shares, which gave me 12.33 dollars.

But this answer isn’t one of the options provided so I'm not sure what I might be missing in the assumptions of the question. Could you help?

Thanks in advance, 
Sofia


In reply to Sofia Lampreia Alves Garcia

Re: Review Quiz - Limits of Debt

by Julio Crego -
Hi Sofia,

Thanks for the question. I think this is something that confuses many people. Unless the question specifies otherwise, we always assume that the shares are bought at the price they have after the announcement.

This is not really an assumption. Assume we are the firm. If we offer a lower price, no one will buy because they know they can wait and get more value. If we offer more, then everyone wants to buy because we are offering too much. Therefore, the buying price must be equal to the price after the announcement.

In the exercise from the slides, I assumed a price of buying lower than the post-announcement price to make the exercise simpler.